I Global Economic Prospects and Policies

International Monetary Fund. Research Dept.
Published Date:
May 1996
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World economic growth has continued, on average, at a satisfactory pace, supported in particular by buoyant growth in many emerging market countries. However, growth slowed more markedly than expected during 1995 in western Europe and North America, leading to further increases in unemployment in some countries from already high levels and also to fears of a new economic downturn. In response, short-term interest rates have been reduced significantly and several countries have taken various fiscal and structural measures to revive confidence and stimulate job creation. While growth has clearly slowed below potential in some cases, the factors that appear to lie behind the slowdown are likely to prove temporary. There are also now clearer signs of an upturn in Japan. Overall, there do not seem to be grounds to expect a prolonged or generalized slowdown, and global growth is projected to pick up to around 4 percent a year in 1996 and 1997 from the rate of 3½ percent to which it slipped last year (Table 1).

Table 1.Overview of the World Economic Outlook Projections(Annual percent change unless otherwise noted)
Current ProjectionsDifferences from October 1995 Projections
World output3.
Industrial countries2.
United States13.
United Kingdom3.
Seven countries above2.
Other industrial countries3.
European Union2.
Developing countries6.
Middle East and Europe0.
Western Hemisphere4.
Countries in transition-8.8-
Central and eastern Europe-
Excluding Belarus and Ukraine3.
Russia, Transcaucasus, and central Asia-14.8-
World trade volume (goods and services)
Industrial countries9.
Developing countries9.011.810.
Countries in transition4.310.911.610.1
Industrial countries8.
Developing countries12.
Countries in transition5.311.88.97.2
Commodity prices in SDRs
Consumer prices
Industrial countries2.
Developing countries48.019.912.69.80.4-0.3
Countries in transition264.8128.238.213.6-19.612.8
Six-month LIBOR (in percent)4
On U.S. dollar deposits5.
On Japanese yen deposits2.
On deutsche mark deposits5.
Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during February 16-March 14, 1996, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

Exact comparison with the growth estimates in the October 1995 World Economic Outlook is not possible because of the change from a fixed-base-year method to a chain-weighted method of measuring real GDP. introduced in late 1995. In qualitative terms 1995 growth was somewhat weaker than estimated half a year ago, whereas the projection for 1996 is broadly similar to the one published in October.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $17.17 in 1995; the assumed price is $17.39 in 1996 and $16.12 in 1997.

Average, based on world commodity export weights.

London interbank offered rate.

Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during February 16-March 14, 1996, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

Exact comparison with the growth estimates in the October 1995 World Economic Outlook is not possible because of the change from a fixed-base-year method to a chain-weighted method of measuring real GDP. introduced in late 1995. In qualitative terms 1995 growth was somewhat weaker than estimated half a year ago, whereas the projection for 1996 is broadly similar to the one published in October.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $17.17 in 1995; the assumed price is $17.39 in 1996 and $16.12 in 1997.

Average, based on world commodity export weights.

London interbank offered rate.

The most pronounced deterioration in cyclical conditions since early 1995 has been in Germany, France, several other countries closely linked to the deutsche mark, and Switzerland. The timing and strength of the expected pickup in activity in these countries is somewhat uncertain, but the conditions appear to be in place for a quickening in the pace of economic growth during 1996. A strengthening of activity in these countries is essential to put unemployment securely on a downward path and to facilitate fiscal consolidation in accordance with the agreed timetable for Economic and Monetary Union (EMU). Conversely, a prolonged period of lackluster growth could exacerbate doubts about the EMU timetable and might lead to tensions in financial markets.

In other regions, the possibility of shifts in financial market sentiment in response to policy slippages also remains a potential downside risk. As witnessed on several occasions in the recent past, financial markets are highly sensitive to concerns about economic and financial imbalances, while the global economy has become more vulnerable to adverse market reactions (see the October 1995 World Economic Outlook). When doubt has arisen about the resolve of policymakers to tackle problems, markets have demonstrated their ability to force the necessary policy changes at substantial cost. Market discipline on economic policies, in contrast to self-discipline, often involves excessive volatility in asset prices, with seriously adverse consequences for activity and employment. Fortunately, it has become increasingly recognized that the global integration of markets requires greater policy discipline, and this recognition has been contributing to a strengthening of policy fundamentals in a growing number of countries in all regions.

In fact, a number of positive trends and developments point to the likelihood of continued, relatively solid world growth in the period ahead (Chart 1). Global inflationary pressures remain subdued. Notwithstanding an upturn in bond yields since January, real long-term interest rates are significantly lower than in most of the period since the early 1980s, owing in part to perceptions of stronger commitments to the reduction of fiscal imbalances in many industrial countries. Equity prices have continued to rise, reflecting strong profit performance as well as lower interest rates. And exchange rates among the major currencies have returned to levels more consistent with fundamentals, following the misalignments that arose in the spring of 1995. The correction of the overshooting of the yen has been particularly helpful in brightening the outlook for the Japanese economy.

Chart 1.World Indicators1

(In percent)

The global expansion is expected to continue with the growth of world output and trade above trend, while inflation should remain contained in industrial countries and slow further in developing countries.

1 Blue shaded areas indicate IMF staff projections.

2 Goods and services, volume.

3 GDP-weighted average of ten-year (or nearest maturity) government bond rates for the United States, Japan, Germany, France, Italy, the United Kingdom, and Canada. Excludes Italy prior to 1972.

Moreover, capital flows to emerging market countries have been generally well sustained following the containment of spillover effects from the Mexican crisis. Recoveries already seem to be under way in both Mexico and Argentina, and activity remains buoyant in many other emerging market countries where the danger of overheating appears to have subsided. In the transition economies of central and eastern Europe, the momentum of growth seems to have been stronger than projected Last fall. There are also signs that output may have begun to recover in Russia. Some of the poorest countries, especially in Africa, have strengthened their growth performance and prospects as a result of intensified adjustment efforts. And world trade has continued to expand faster than past relationships between output and trade growth would seem to predict, reflecting the liberalization of trade and the trend toward current account convertibility in recent years together with the dynamic forces of globalization. Clearly, progress in implementing policies consistent with the global strategy set out by the Interim Committee three years ago, and reaffirmed in its October 1994 Madrid Declaration.1 has brought significant results in many areas.

At the same time, it is apparent that many problems need to be addressed more adequately to strengthen growth in the medium to longer run, to reduce risks of adverse financial market reactions, and to enhance countries’ resilience to economic disturbances. Despite some progress, budgetary imbalances in industrial countries remain a source of upward pressure on real interest rates and thus continue to crowd out private investment. Not only do these fiscal problems need to be addressed in a timely manner, but also early reforms of pension and health systems are needed to preempt even greater budgetary pressures in the future as populations age. There has been considerable progress since the early 1980s in the deregulation of financial markets and in other structural reforms, including further trade liberalization. In many countries, however, and especially in Europe, reforms of labor markets remain essential to reduce structural unemployment and to help alleviate fiscal imbalances.

Most developing countries have reduced fiscal imbalances substantially during the past decade. Together with trade liberalization and other structural reforms this has contributed to their robust economic performance in recent years. Many, however, continue to divert scarce resources from productive investment through large fiscal deficits. In addition, quasi-fiscal or off-budget involvement by governments in economic activity adversely affects economic incentives and growth in many countries. The transition countries also have achieved remarkable progress toward maeroeconomic stability, and their budgetary imbalances have narrowed sharply. But in many cases fiscal deficits are still too large, and continuing government intervention in the economy on behalf of ailing sectors, including through off-budget operations, often remains a threat to the sustainability of recent reductions in inflation. Since such interventions are shielding enterprises and consumers from full exposure to market forces, these practices are also delaying the process of structural transformation and jeopardizing the prospects for sustained economic recovery.

Because many of these macroeconomic and structural policy challenges—which are often interrelated—are in the fiscal area, fiscal policy receives special attention in this issue of the World Economic Outlook.

Industrial Countries

Industrial country growth in 1995 was somewhat weaker than projected six months ago as the pace of expansion slowed significantly during the year in most countries. The slowdown, however, was far from uniform and was desirable in some cases to prevent the buildup of inflationary pressures. In the United States, although growth moderated to only 1¼ percent in the year to the fourth quarter of 1995, the economy, five years into its expansion, remained close to full capacity utilization: and by early 1996 there were signs of a renewed pickup. In Japan, activity remained lackluster under the influence of the strong yen and the uncertainties resulting from mounting problems in the financial sector, but by year-end, there were growing signs that the recovery was under way. In Europe, performance differed somewhat between the countries whose currencies have depreciated in recent years—including Italy, the United Kingdom, Sweden, and Spain—and the strong currency countries—Germany, France, other countries whose currencies have been kept closely linked to the deutsche mark, and Switzerland. In the former group—the “outer ring”—growth was better sustained and the slowdown that did occur was helpful in containing above-average inflation rates. In the hard currency group—the “inner core”—activity stagnated in the second half of 1995 and unemployment turned upward again before the recovery had made much headway (Chart 2).

Chart 2.Major Industrial Countries: Unemployment Rates

(Seasonally adjusted; in percent of labor force)

In continental Europe, unemployment rates have only fallen slightly since their cyclical peaks anti have begun to edge up in recent months.

1 Data through December 1991 cover west Germany only; data beginning with January 1992 are based on a revised methodology and are not comparable with earlier data.

Except in the United States and other countries at advanced stages of their recoveries, an economic slowdown during 1995 was not generally expected early in the year; and particularly in the inner core of Europe, the extent of the slowdown became apparent only quite recently. In retrospect, it appears that the substantial, worldwide rise of long-term interest rates during 1994 subsequently had a greater depressing effect on industrial country activity than expected. In addition, some of the effects of fiscal consolidation that were initially absorbed in some countries by private saving later materialized to reduce demand. Other developments unexpected at the beginning of 1995 also contributed to the slowdown: the sharp contraction in Mexico and the dramatic improvement in Mexico’s trade balance had a significant negative impact on the U.S. economy early in the year; the large appreciation of the yen in the spring undercut the incipient Japanese recovery; and for the inner core countries of Europe, the appreciation of their currencies against the U.S. dollar and against other European currencies had a similar if less pronounced effect.

With the benefit of hindsight, it is also clear that the differences in performance between the inner core and the outer ring of European countries owe something to differences in the mix and stance of their economic policies. In the outer ring countries, relatively large fiscal imbalances have necessitated fairly restrictive fiscal stances, but monetary conditions have eased significantly during the past two to three years, especially taking into account not only the declines in short-term interest rates but also the depreciations of their currencies in the wake of the 1992-93 crises in the European Monetary System (EMS). In the hard currency group, not only have fiscal policies been restrictive, albeit to varying degrees—some countries did not take sufficient advantage of the 1994 recovery to reduce their fiscal deficits—but also monetary conditions—again broadly defined to take account of exchange rate developments—have remained relatively light, at least until recent months. On balance, for western Europe as a whole, for which the movements in exchange rates had relatively little net effect on aggregate demand, the overall stance and mix of policies appear to have been more of a restraining factor than previously thought. The brunt of that restraint, however, has been borne by the strong currency countries, where it seems to have been amplified by unwarrantedly high wage settlements in Germany and confidence factors, including uncertainties about the future stance of policies and concern about the Maastricht convergence process. These forces have held back private consumption, as well as business investment, and have also led to reductions of inventories.

Economic policies, of course, reacted to these unexpected developments. However, economic policies, which always operate with a lag, could not have offset the unforeseen elements in the slowdown of activity in 1995. While monetary policies were generally eased as information became available about receding price pressures and slowing activity, for much of the year, assessments of the economic situation and prospects in Europe would not have justified a significantly faster easing than in fact occurred.

Looking ahead, however, there are good reasons to expect growth in Europe to pick up again in the course of 1996. The view that the recent weakness is temporary is supported by several developments. Most important. policy stances seem to be converging in a helpful way in the two groups of countries. Specifically, monetary conditions in the strong currency countries have eased markedly during the past year and fiscal consolidation efforts are also expected to strengthen, correcting the policy mix in a direction that is likely to be more conducive to growth. (The policy assumptions underlying the projections are set out in Box 1.) Moreover, progress toward fiscal consolidation in the outer ring has allowed risk premiums in interest rates to decline in most cases and has also helped to correct some of the undervaluation in currencies, although there is scope for further exchange rate appreciation as fiscal consolidation continues. Also, there are already some indications that the inventory adjustment process may have run its course. While the timing and strength of the expected pickup is somewhat uncertain, a prolonged period of weakness is unlikely.

Nevertheless, to facilitate a robust recovery in Europe, and to insure against downside risks, it is important that the available scope for further easing of monetary conditions in the hard currency countries be fully utilized without compromising the goal of medium-term price stability. Room for further declines in short-term interest rates in these countries is suggested by their large margins of slack, subdued price pressures, the strength of their exchange rates, and modest growth of monetary aggregates in most cases during the past year. It is particularly important that the stance of monetary policy provides support for activity as fiscal consolidation efforts continue. Further fiscal consolidation must be actively pursued in the weak-currency countries as well; monetary policy in these countries needs to be firmly geared to achieving medium-term inflation objectives.

The continued need for fiscal consolidation reflects the paramount importance of re-establishing a more balanced policy mix conducive to stronger sustained growth in Europe. Further fiscal consolidation is also essential to allow the Maastricht process to proceed as planned. For these reasons and because of the implications for interest rates and financial market confidence if fiscal policy were eased, it is imperative to maintain adequate progress toward budgetary consolidation, particularly on the expenditure side of government budgets. Some quickening in the pace of expenditure consolidation would be in order in virtually all countries. If, contrary to the central projection in this report, there were a prolonged period of weakness, adequate progress in reducing structural imbalances would still allow fiscal policy to provide automatic stabilizers for activity. Further progress toward labor market reform also remains essential to tackle the root causes of high structural unemployment.

The weakening of activity in much of Europe and associated increases in fiscal deficits have prompted concerns about the feasibility of the timetable for EMU. Respect for the conditions for participation set out in the Maastricht Treaty is important and the achievement of the Maastricht fiscal criterion, given the projected pickup in growth during 1996, is clearly feasible and worthwhile for most EU members. At the same time, the historic decision to introduce a common currency, and the related decision on which countries will initially participate in this endeavor, presumably will reflect broader political and economic considerations. The introduction of a common currency and the establishment of an independent European central bank dedicated to the goal of price stability will bring potentially important long-run benefits in the form of greater financial and macroeconomic stability among the participants in the monetary union. For these benefits of monetary union to be realized, its participants will need to achieve and sustain a high degree of fiscal discipline. This suggests that the assessment of progress toward meeting the conditions for participation should be viewed in a longer-run context, taking into account the ability of governments to correct structural as well as actual fiscal imbalances and to make binding commitments to appropriate mechanisms for fiscal discipline beyond the test year of 1997 (see Appendix to Chapter II).

Box 1.Policy Assumptions Underlying the Projections

Fiscal policy assumptions for the short term are based on official budgets adjusted for any deviations in outturn as estimated by IMF staff and also for differences in economic assumptions between IMF staff and national authorities. The assumptions for the medium term take into account announced future policy measures that are judged likely to be implemented. In cases where future budget intentions have not been announced with sufficient specificity to permit a judgment about the feasibility of their implementation, an unchanged structural primary balance is assumed. For selected industrial countries, the specific assumptions adopted are as follows.

United States: For the period through FY 1999, fiscal revenues and outlays at the federal level are based on the average between those assumed in the administration’s March 1996 budget proposal (using Congressional Budget Office assumptions) and the Congress’s Balanced Budget Act of November 1995, after adjusting for differences between the IMF staff’s macroeconomic assumptions and those of the Congressional Budget Office. From FY 2000 onward, the federal government primary balance as a proportion of GDP is assumed to remain unchanged from its projected FY 1999 level.

Japan: Measures that have already been announced are assumed to be implemented over the medium term. These measures include an increase in the consumption tax rate from 3 percent to 5 percent in 1997 and a simultaneous end to the temporary income tax cut, implementation of the 1994 pension reform plan, and achievement of the medium-term public investment plan.

Germany: The 1996 projection for the general government is based on the 1996 federal budget and recent official estimates for the other levels of government, adjusted for differences in macroeconomic projections. In 1997, the social security funds are assumed to close their deficits mainly through higher contribution rates (as mandated by existing legislation), while other levels of government are assumed to follow unchanged policies. Projections for 1998 and beyond are predicated on an unchanged structural primary balance.

France: Projections incorporate the 1996 budget of the state and all policy measures announced by the authorities, including the FF 20 billion in additional expenditure cuts announced in March. The projections, however, do not include any measures (as yet unspecified and unannounced) that might be taken in connection with the 1997 budget. The reference point for social security is the reform package announced in November last year. Some of the measures in this package have already been implemented and are included in the projection; several other important measures, concerning mainly the control of medical expenditure, are also assumed to be implemented in 1996 and 1997; the relatively small number of measures that have been dropped by the government are excluded. However, the revenues of the social security system will be adversely affected by the slowdown in economic activity in the second half of 1995 and the relatively slow pace of economic growth in 1996. Projections for 1998 and beyond assume an unchanged structural primary balance.

Italy: Projections for 1996 are based on the official budget. adjusted for slippages from the authorities’ estimates of the likely yield of the legislated measures and for known expenditures not provided for (current and back payments under the Constitutional Court sentences on pensions and the phased payment of tax refund liabilities postponed from 1995). Interest on zero-coupon bonds is included as it accrues, rather than when it is paid (as is the case in the official presentation). For 1997-98, it is assumed that the measures (manovra) announced in the three-year plan are fully implemented and yield the officially estimated amounts. Thereafter, the structural primary balance is presumed to remain unchanged.

United Kingdom: The budgeted three-year spending ceilings are assumed to be observed. Thereafter, noncyclical spending is assumed to grow in line with potential GDP. For revenues, the projections incorporate, through the three-year budget horizon, the announced commitment to raise excises on tobacco and road fuels each year in real terms; thereafter, real tax rates are assumed to remain constant.

Canada: Federal government outlays for departmental spending and business subsidies conform to the medium-term commitments announced in the March 1996 budget. Other outlays and revenues are assumed to evolve in line with projected macroeconomic developments. However, the unemployment insurance (UI) premium is assumed to fall in 1998/99 to a level that is consistent with an unchanged surplus in the UI account. The fiscal situation of the provinces is assumed to be consistent with their stated medium-term deficit targets.

Australia: Projections are based on the Commonwealth government’s announced medium-term fiscal consolidation strategy in the 1995/96 budget and unchanged policies for the state and local governments.

Netherlands: Projections are based on the government’s medium-term target expenditure path for the central government and social security. Only part of the room under the general government annual deficit ceilings is allocated to deficit reductions; the bulk is allocated to tax and social security premium reductions. From 1999 onward, the general government structural balance is assumed to remain constant.

Spain: Projections for 1996 are based on the rollover of the 1995 budget as modified by several decree laws, and adjusted for differences in macroeconomic assumptions and similar slippages on budgeted expenditures as occurred in 1995. For 1997, revenue estimates are based on the assumption of an unchanged tax structure, but the personal income tax schedule and excise taxes are adjusted for inflation.

Sweden: The medium-term projections are based on the government’s multiyear consolidation program approved by Parliament in 1995.

Switzerland: Projections for 1997-99 are based on official estimates for current services. Thereafter, the general government structural primary balance is assumed to remain constant.

* * *

Monetary policy assumptions are based on the established framework for monetary policy in each country, which in most cases implies a nonaccommodative stance over the business cycle. Hence, it is generally assumed that official interest rates will firm when economic indicators, including monetary aggregates, suggest that inflation will rise above its acceptable rate or range and ease when the indicators suggest that prospective inflation does not exceed the acceptable rate or range and that prospective output growth is below its potential rate. For the ERM countries, which use monetary policy to adhere to exchange rate anchors, official interest rates are assumed to move in line with those in Germany, except that progress on fiscal consolidation may influence interest differentials relative to Germany. On this basis, it is assumed that the London interbank offered rate (LIBOR) on six-month U.S. dollar deposits will average 5.6 percent in 1996 and 5½ percent in 1997; that the three-month certificate of deposit rate in Japan will average 1 percent in 1996 and 2.4 percent in 1997; and that the three-month interbank deposit rate in Germany will average 3.6 percent in 1996 and 4.6 percent in 1997.

Budgetary problems are a threat to durable and satisfactory growth performance in almost all industrial countries. To be sure, many countries have worked in recent years to reduce excessive fiscal deficits, and policymakers continue to express their firm commitment to restoring better balance in public finances. But fiscal consolidation increasingly requires cuts in expenditure programs that are strongly supported by particular groups. Since the benefits of such cuts to society as a whole are not so visible and may be felt mainly in the longer run, the political difficulties associated with them—illustrated by recent social unrest in France, the budgetary stalemate in the United States, and the costly bailouts of some large enterprises in several European countries—may delay the progress needed. The risk of slippages in consolidation efforts is all the more disquieting since the fiscal burden of public health and pension systems as presently structured is projected to increase considerably throughout most of the industrial world in the coming decades.

Increases in taxes are unlikely to provide a substantial part of the solution to the fiscal problems, because tax burdens are already very high in most countries and there is concern that higher levels of taxation may further distort resource allocation, adversely affect employment, and reduce long-term growth. There is also preliminary evidence, reported in Chapter III, that fiscal consolidation based on tax increases has been much less effective in achieving fiscal goals than measures to contain the growth in expenditures. Indeed, many industrial countries could probably strengthen their economic performance by reducing the shares of government expenditures and taxes in GDP. The additional pressures on public finances associated with aging populations underscore the need for fundamental reforms of public expenditure programs. In many cases, it will be necessary to rethink the role of the public sector in achieving key social objectives.2 A particularly important area of reform is the broad range of social expenditure policies and regulations that impede the functioning of labor markets.

In contrast to the recent mixed growth performance of the industrial countries, low inflation remains a particularly encouraging aspect of current economic conditions in most of them. The countries most advanced in the expansion, including the United Stales and the United Kingdom, began to tighten monetary conditions in 1994 to pre-empt potential inflationary pressures. This vigilance met with considerable success, and moderate inflation and growth have allowed these countries to ease monetary conditions in recent months. Elsewhere, success with inflation has allowed monetary authorities to respond to currency appreciations, rising unemployment, and moderate monetary growth by reducing official interest rates. In Japan, virtually all room for maneuver in easing monetary policy has now been used, and the accommodative stance established last summer is assisting in the recovery of activity; while there is little near-term risk of inflation, monetary conditions will obviously need to firm once the recovery is well established. In Germany and many other European countries, official interest rates have been lowered substantially in the past year because of mounting concerns about the sluggishness of monetary indicators and activity, and in the context of generally strong currencies. In the circumstances, this easing has involved no danger of stimulating inflation and thereby jeopardizing medium-term growth prospects.

With regard to prospects for individual countries, growth in the United States is expected to be sustained at rates close to potential in 1996–97 with inflation remaining subdued.3 Fears of slower growth in 1996 have diminished with buoyant data, especially for employment, for the opening months of the year, and the economy will continue to be boosted by the easing of monetary conditions that has occurred since mid-1995. Evidence of a strengthening of activity has removed expectations of a further easing of monetary policy and has contributed to the recent rise in long-term interest rates. Nevertheless, long-term interest rates remain well below their level in early 1995. Further fiscal consolidation remains critical to strengthen national saving and improve long-term growth prospects.

Although the U.S. budget deficit has fallen sharply in recent years, it threatens to increase again in the absence of new measures. Unfortunately, the administration and Congress have so far failed to resolve their differences on specific measures to balance the budget over the medium term, and the proposals of both sides are disappointing with respect to the envisaged speed of consolidation. To justify and sustain confidence in financial markets, the debate over the budget should be resolved in a manner that ensures continued deficit reduction in 1996 and the next several years. A back-loaded deficit reduction program depending heavily on unspecified, future measures could raise fears that the promised deficit-reductions might not be delivered, Moreover, substantial tax cuts should be postponed until deficit reduction is substantially achieved.

In Canada, the pace of economic recovery slowed markedly in 1995 owing to the tightening of monetary conditions early in the year and the risk premiums in interest rates that resulted from political and economic uncertainties, as well as the slowdown in the United States. Following the referendum on Quebec in October, confidence improved and interest rates fell significantly, which should permit the pace of economic activity to pick up during 1996. Fiscal imbalances have diminished considerably in recent years but the federal and provincial governments will need to ensure that further consolidation is achieved in 1996 and over the medium term. Inflation has remained low, which provides some flexibility for further easing of monetary policy if warranted by cyclical considerations and by further progress on the fiscal front. Overall, conditions are good for Canada’s expansion to proceed at a healthy rate.

Economic activity now appears to be picking up in Japan after protracted sluggishness that has left the economy with considerable margins of unused resources. The supportive stance of both monetary and fiscal policies and the correction of the yen’s excessive appreciation in early 1995 provide good reasons for expecting recovery to continue in 1996. Confidence in the financial system has begun to improve with the announcement of a strategy for resolving the financial problems of Japanese banks, steps to deal more effectively with failed institutions, and plans to strengthen banking supervision. Nevertheless, extricating financial institutions from their bad loans problem could act as a drag on the pace of recovery. Fiscal policy is appropriately aimed at providing continuing support in 1996 but budgetary consolidation will need to resume when the recovery gathers enough momentum to permit a withdrawal of stimulus.

In those European countries where the expansion has been marking time since mid-1995, evidence of a turnaround is still mixed even though conditions seem to be in place for a resumption of growth in the second half of 1996. In Germany, the strength of the exchange rate and the disappointing outcome of the 1995 wage round seem to have hurt the investment climate while export growth has also slowed. A related problem has been a drop in consumer confidence. Declines in interest rates and a buoyant equity market provide some basis for optimism with respect to chances of a pickup later in 1996, although the rise in real GDP is unlikely to be more than about 1 percent for the year. Even though growth in the key monetary policy indicator, M3, picked up somewhat in early 1996, subdued inflation and slack in the economy suggest room for further reduction of short-term interest rates. Following a larger-than-expected fiscal deficit in 1995, it is important to maintain discipline on the side of discretionary expenditures, although some allowance for the working of automatic stabilizers through the accommodation of weaker revenues would seem warranted. There is also a need to limit the deficits of state and local governments as well as pension funds; these were in fact the major source of the increase in the overall fiscal deficit last year.

Weakness of both consumer and investor confidence also contributed to the stagnation of activity in France in the second half of 1995 and to the downgrading of growth projections for 1996 to some 1–1½ percent. As in Germany, however, and as discussed earlier, activity is expected to strengthen during the year. Resistance to the government’s fiscal and structural reform proposals, together with the renewed rise in unemployment to almost 12 percent of the labor force in early 1996. may have contributed to the waning of confidence. The government’s firm stance has helped to re-establish market confidence, strengthen the franc, and permit an easing of short-term interest rates relative to Germany. Even though there is still a risk of slower growth with the possibility of renewed turbulence in the foreign exchange markets, this risk can be limited by the continuation of efforts to implement a more balanced policy mix.

Box 2.United States: Chain-Weighted Method for Estimating Real GDP

A “chain-weighted” procedure recently became the primary method used by the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce to separate nominal (or current-dollar) changes in GDP into their quantity-change and price-change elements. It thus became the primary method used to measure growth in the U.S. economy.1 This method is free of the biases that tended to arise with the previously used “fixed-base-year” method because of structural shifts in the U.S. economy and. in particular, the sharp decline in the price of computers.

Under the fixed-base-year method, real GDP was estimated by using prices in a particular base year—most recently, 1987—to value each category of expenditure in the economy. Real GDP was calculated as the sum of the expenditure components valued at base-year prices; the growth in real GDP was simply the percent change in this sum. A major advantage of this technique was that real GDP could easily be decomposed into its parts (e.g., the major expenditure aggregates of private consumption, investment, government spending, and net exports) so that it was relatively straightforward to determine how each expenditure component contributed to growth.

Shifts in the structure of the U.S. economy, however, highlighted the sensitivity of GDP growth estimated by the fixed-base-year method to the choice of base year. The more distant in the past was the base year, the greater was the weight given to expenditure items where prices had subsequently been declining, or rising relatively slowly. These also tended to be the expenditures that had exhibited strongest growth, owing to substitution in demand away from goods whose relative prices were rising. As a result, the earlier was the base year, the more upwardly biased were estimates of subsequent real GDP growth. And when the base year was eventually updated—typically every five years—estimates of real GDP growth were revised downward. The sharp declines in computer prices beginning in the 1980s, and the dramatic expansion in the importance of this sector in the economy, highlighted this shortcoming of the fixed-base-year method. The BEA has estimated that the earlier change in the base year from 1982 to 1987 resulted in an average decline of 0.3 of 1 percentage point in GDP growth for the period 1982–88.

The chain-weighted method shifts the base year forward each year and therefore allows for continuous updating of weights. This has the advantage of eliminating the upward bias to real GDP growth that tended to be a feature of the fixed-base-year method (see chart). For example, the growth rate of real GDP for 1995 is calculated by averaging two estimates of growth: one with 1995 as the base year and the other with 1994 as base. Use of the chain-weighted method reduces the risk of potentially large revisions to historical estimates of real GDP. Although with the chain-weighted method it is not possible to decompose exactly the level of real GDP into its components, it is possible to decompose the growth of real GDP into the contributions of changes in the different (expenditure or output) components. It has been estimated that the change from 1987 fixed weights to the chain-weighted methodology lowered measured real GDP growth in 1995 by about ½ of 1 percentage point.

Chain-Weighted and Fixed-Base-Year Estimates of Real GDP

(Percent change from four quarters earlier)

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

1 Base year is 1987.

Beginning with this issue of the World Economic Outlook, national accounts data and projections for the United States are based on chain-weighted estimates.

1Among other industrial countries, Norway and the Netherlands also use the chain-weighted method to estimate real GDP.

Following vigorous expansion in 1994, me United Kingdom experienced a moderation of growth during 1995, which helped to alleviate inflationary pressures. The economy is supported by gains in external competitiveness since 1992 and by recent declines in interest rates, and the outlook is for continued moderate growth, with inflation easing gradually now that earlier input cost increases appear to have worked through. The fiscal measures announced in the November budget were neutral, but mainly owing to shortfalls in revenue performance the path of medium-term fiscal consolidation has been shifted back a year. Little if any further easing of monetary conditions would seem warranted unless activity were to weaken markedly.

In Italy, the lira’s sharp depreciation between 1992 and early 1995 led to gains in external competitiveness that helped buoy economic activity, while at the same time boosting inflation. Despite the difficulties affecting major trading partners and political uncertainties at home, growth was relatively high in 1995 because of exceptionally strong exports and is expected to remain stronger than in most other European countries in 1996. Visible progress in fiscal consolidation, together with favorable international market conditions, helped the lira to regain ground and to narrow the large interest-rate differentials relative to Germany. For the period ahead, it is essential to sustain fiscal consolidation to bring about a favorable cycle of deficit reduction, interest rate declines, a desirable firming of the lira, reduced inflation, and a more balanced economic expansion; however, there is a risk that political uncertainties and policy slippages may reverse recent improvements in economic and financial conditions.

Among the other industrial countries, Sweden, Finland, and Spain have also experienced both relatively rapid export growth following earlier gains in competitiveness and improvements in financial market confidence thanks to progress in reducing fiscal imbalances. In Ireland, the expansion has remained particularly buoyant with few signs of inflationary pressures. In Denmark and Norway, a slowing of growth since mid-1995 has alleviated the danger of overheating stemming from their relatively strong economic expansions since 1993. Switzerland has been particularly seriously affected by the strength of its currency—up by 20 percent in real effective terms since 1992—and by a loss of marker shares at home and abroad. As a result, real GDP is projected to grow by less than 1 percent in 1996, not much better than in 1995. In response to the strength of the exchange rate and weakness of activity, official interest rates have been eased considerably and long-term interest rates have dropped to about 4 percent, the lowest in Europe.

While most other industrial countries continue to struggle with fiscal problems, New Zealand provides a remarkable contrast, with the budget having been in surplus since 1994. Helped by pathbreaking structural and institutional reforms, the disciplined fiscal policy pursued by New Zealand has contributed to above-average growth, declining unemployment, and price stability. Australia’s economic performance has also been very good in recent years, with a significant improvement in its fiscal position, although inflation edged up somewhat in 1995. For both countries, near-term prospects remain better than for most other industrial countries although fiscal and monetary policies will need to be alert to the challenge of maintaining growth in a way that avoids inflationary pressures and ensures a sustainable current account position.

Developing Countries

The growth momentum of many developing countries and the developing world’s increased resilience to external disturbances, noted in earlier issues of the World Economic Outlook, are strong reasons to expect that the recent weakness in some industrial countries will not extend to a generalized global slowdown. The emerging market economies of Asia are likely to remain particularly buoyant, although growth is expected to moderate in several of them. This should help to alleviate inflationary pressures and reduce current account imbalances associated in part with large private capital inflows. Nevertheless, actions already taken in Indonesia, Malaysia, and Thailand to dampen domestic demand may need to be followed up by additional measures of restraint.

The Chinese economy appears to have achieved a soft landing after a prolonged period of overheating. Inflation has fallen to less than half the rate seen in 1994, and output growth has slowed to about 10 percent; continuing rapid monetary expansion, however, puts this progress at risk. The strength of the external sector provides a good opportunity for accelerating trade liberalization and for removing the remaining exchange restrictions on current transactions. Other policy priorities include the strengthening of public finances. the hardening of budget constraints on state-owned enterprises, and reforming the financial sector.

Elsewhere in Asia, India’s growth remained strong in 1995. reflecting a surge in investment and strongly growing exports, but is expected to moderate somewhat during 1996 as higher interest rates restrain domestic demand. Further progress with budgetary consolidation and structural reform after the elections are essential to sustain and strengthen growth. In the Philippines, economic recovery is expected to become more firmly established this year. Continued implementation of fiscal and structural reforms as well as a firm anti-inflationary monetary stance are needed to keep the economy on a sustainable growth path.

In Latin America, the consequences and spillovers from the financial crisis that engulfed Mexico in late 1994 and early 1995 have eased substantially. In Mexico, following a difficult year that saw real output contract by almost 7 percent, the recovery that has already begun is expected to gather strength during 1996. There are still risks arising from fragilities in the banking sector, and continuing fiscal discipline will be needed to maintain market confidence. In Argentina also, the adjustment efforts undertaken in the wake of the repercussions from the Mexican crisis should permit the recovery that appears to be under way to gain momentum in 1996. In Brazil, monthly inflation was brought down from 43 percent in the first half of 1994 to 1½ percent in 1995. This reflects the success of the Real Plan, which included the elimination of most forms of backward-looking indexation, the introduction of a new currency, and tight credit policy, which subsequently led to a nominal appreciation of the exchange rate. The fiscal situation weakened in 1995, however, and a strengthening of the public finances and structural reforms is critical to ensure the continued success of the Real Plan and stronger growth on a sustained basis. Chile, the strongest performer in Latin America, tightened its monetary policy late in 1995 amid signs of overheating. Growth is expected to slow from 8 percent in 1995 to a still impressive 6 percent in 1996, while inflation should moderate further.

Growth performance in Africa, especially in sub-Saharan Africa, is expected to continue to improve as a result of the implementation of stronger macroeconomic and structural policies in an increasing number of countries in recent years. Most countries of the CFA franc zone have seen continued recovery following the restoration of competitiveness by the devaluation of 1994 and supporting policies. In South Africa, activity, especially in manufacturing, is picking up with the country’s reintegration into the global economy. Strong recovery is also under way in Ghana, Kenya, and Uganda. In a number of other countries, however, including Nigeria and Zaïre, economic conditions remain difficult. Further policy improvements will be needed for significant and sustained increases in living standards to be achieved.

In the Middle East and Europe region, economic performance and prospects have strengthened in several countries as a result of stronger macroeconomic and structural policies, as well as some overall improvement in regional stability (see Annex II). Growth in Jordan is expected to remain buoyant thanks to sustained structural adjustment policies. For many of the oil producing countries, however, large (albeit declining) fiscal deficits and weak oil prices continue to cloud the outlook. Economic activity in Egypt has continued to be constrained by structural impediments. Turkey saw rapid expansion in 1995, but sustained growth is threatened by continuing macroeconomic imbalances.

Notwithstanding many remaining problems, strengthened fiscal policies have played a key role in the solid economic performance of the developing countries in recent years. Overall, fiscal deficits at the level of central government have been cut by two thirds since the mid-1980s and currently average about 2 percent of GDP. In the Western Hemisphere, the remaining imbalances are relatively small, but the low national saving rates in that region point to the importance of further improvements in fiscal positions. In Asia, the overall picture has also improved although persistently large fiscal imbalances in some countries, particularly in the Indian subcontinent, continue to divert scarce resources from private investment. In several of the emerging market countries in Asia, some tightening of fiscal policies would help alleviate the risks associated with large capital inflows. In the Middle East, average fiscal deficits have fallen from over 12 percent of GDP in 1983–88 to 4 percent of GDP in 1995. But further efforts are clearly required, especially in some of the oil exporting countries. The average fiscal deficit in Africa has been halved since 1993 to also reach about 4 percent of GDP in 1995 (the median deficit has fallen from 7 percent of GDP in 1993 to 4½ percent of GDP in 1995).

Weaknesses in revenue mobilization, which reflect not only narrow tax bases but also inefficient tax administrations. are a serious problem in many developing countries. This hampers the ability of governments to provide basic public services and maintain adequate levels of investment in infrastructure. And in some cases it also contributes importantly to large fiscal deficits that undermine macroeconomic stability.

In many developing countries, the emphasis on expenditure reductions in fiscal consolidation may partly have reflected difficulties in mobilizing higher revenues, but there has been a general tendency toward reducing public expenditures in activities that can be carried out more efficiently by the private sector. The share of military expenditures in GDP has also fallen. If sustained, the declining share of public expenditures allocated to less productive activities should permit greater efforts in the areas of education, health care, and poverty alleviation. In addition, and important from a structural as well as a macroeconomic perspective, government intervention in the economy through quasi-fiscal activities has been substantially curtailed in many developing countries thanks to privatization, deregulation, and trade liberalization. Although the overall degree of government intervention in the economy is still often significantly higher than suggested by the ratio of government expenditure to GDP, and often constitutes a serious impediment to higher sustainable rates of economic growth, the general trend is very promising.

Transition Countries

Many of the transition countries have achieved considerable progress with macroeconomic stabilization and reform, and the fruits of their efforts to transform their economies are increasingly visible. Clearly, the transition process is working.

Following the turnaround in activity in 1994, the recovery in central and eastern Europe (excluding Belarus and Ukraine) gained further momentum in 1995. The region is expected to continue to grow at about the same pace in 1996–97 as last year—4 to 5 percent a year—with the potential for even stronger growth over the medium term if the policy challenges facing these countries are successfully addressed. Poland, the Czech and Slovak Republics, and Slovenia have achieved some of the most impressive results. Disciplined financial policies, structural reforms, trade liberalization, and rapid growth of trade, especially with western Europe, are important factors contributing to the rapid transformation that is taking place in these economies. Among the central Asian transition countries, Mongolia’s economic performance also shows the fruits of the country’s reform efforts.

Many of the countries that are less advanced in the transition have made significant progress with structural reform, including price liberalization, privatization, and the dismantling of trade barriers. There has also been progress toward macroeconomic stability, although the sustainability of recent reductions in inflation is in doubt in some cases. Output appears to have bottomed out during 1995 in Russia, and a convincing recovery should emerge during 1996 provided policies stay on track. Economic prospects have also improved in Kazakstan, the Kyrgyz Republic, Moldova, Armenia, Georgia, and Uzbekistan. Ukraine made considerable progress with stabilization and systemic reform in 1995; in the absence of policy slippages, the decline in output should bottom out in 1996. In Belarus, Tajikistan, and Turkmenistan, where reform and stabilization efforts have been inadequate thus far, the contraction of output may well continue. Armed conflicts continue to delay the necessary reforms in several other countries, but throughout the former Yugoslavia prospects for recovery have now improved following the cessation of hostilities in Bosnia and Herzegovina.

Initial success with stabilization is no guarantee that inflation will not re-emerge. In some of the countries that are most advanced in the transition, capital inflows have helped to ease financing constraints, stimulate activity, and permit a more rapid replacement of obsolete capital equipment. Capital inflows also facilitate privatization and enterprise restructuring, thus promoting the role of market forces in the allocation of resources. However, as in other parts of the world, large-scale capital inflows may increase inflationary pressures unless macroeconomic policies are adjusted appropriately. Moreover, capital flows could prove to be disruptive outflows when domestic or external imbalances are large. To alleviate such risks, Hungary has implemented a program of fiscal consolidation that should put the ratio of external debt to GDP on a sustainable downward path, while Poland has allowed its currency to harden somewhat and the Czech Republic has widened its intervention band.

For the transition countries, achieving and sustaining macroeconomic stability is inextricably linked to the process of enterprise and bank restructuring and the reform of social safety nets. In many of these countries, standard fiscal indicators suggest that the reduction in fiscal imbalances has been accompanied by a substantial decline in government involvement in the economy. Further deficit reduction, however, is needed in most cases. There are also a number of indirect channels through which governments in some of these countries continue to influence resource allocation, including through directed credits and explicit or implicit loan guarantees, as well as by acquiescing in a dangerous accumulation of tax, wage, and inter-enterprise arrears. Moreover, there are likely to be budgetary implications from the substantial portfolios of problem loans in both the state-owned and private banks. Such problems, which vary in magnitude, constitute a potentially serious threat to macroeconomic stability and sustained recovery in some countries because of the possibility that the associated budgetary outlays will be monetized. Moreover, such practices are in many cases preventing or delaying the structural transformation of enterprises and therefore continue to distort economic incentives. The lack of respect for contractual commitments and reluctance of the authorities to enforce payments threaten to undermine the progress toward market-based economies. As emphasized by Adam Smith,

Commerce and manufactures can seldom flourish long in any state which does not enjoy a regular administration of justice, in which the people do not feel themselves secure in the possession of their property, in which the faith of contracts is not supported by law, and in which the authority of the state is not supposed to be regularly employed in enforcing the payment of debts from all those who are able to pay.4

Social concerns are undoubtedly part of the reason for the continued and, in some instances, increased resort to quasi-fiscal measures of support to industry. To overcome this problem, it is necessary to put in place well-targeted unemployment and health insurance systems that will allow social responsibilities to be shifted away from enterprises. There is also an urgent need to reform pension systems. Because of particularly adverse demographic trends, many of the transition countries will need to reduce incentives for early retirement, increase contribution rates, and raise retirement ages in order to put pension systems on a sustainable footing.

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