Chapter

Chapter 1. Main Developments in the World Economy in 1998/99

Author(s):
International Monetary Fund
Published Date:
September 1999
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In 1998/99, financial markets stabilized and economic activity bottomed out in the emerging market economies of Asia, with signs of an economic turn-a-round emerging in some cases by early 1999. During the year, external financing conditions facing emerging market economies deteriorated markedly following the Russian crisis in August, which also, for a time, gave rise to fears of a more widespread credit crunch. Conditions improved following a broad-based easing of monetary conditions among the industrial countries, although Brazil’s crisis in January 1999 caused a temporary setback.

Economic activity in emerging market economies generally was adversely affected, not only by the difficult external financing environment but also by weaker external demand and falling prices for commodity exports. Among the industrial countries, the recession in Japan deepened during 1998 before a sharp rebound in activity in early 1999, and growth in the European Union (EU) waned during the period, but the expansion in the United States remained remarkably strong. World output growth slowed to 2½ percent in 1998 from 4¼ percent in 1997, with preliminary indications of some pickup in early 1999—although growth appeared to remain significantly weaker than during 1994-97 (Table 1 and Figure 1). This fourth global slowdown in a quarter century stemmed mainly from the crises in emerging markets and the Japanese recession.

Commodity prices fell across the board by amounts not experienced since the mid-1980s. Following some sharp declines in early 1998, oil prices lost further ground toward the end of the year—resulting in a decline of more than 30 percent in 1998 as a whole—but most of the 1998 drop was recovered following the announcement in March 1999 of planned production cuts and evidence of a turn around in Asia. Prices of nonfuel commodities weakened steadily over the financial year, and by March 1999 they were more than 15 percent below a year earlier. This downward movement in commodity prices, while contributing to lower global inflation, also reduced real incomes and domestic demand in many commodity-exporting developing countries, with major negative effects on current account and fiscal positions in some cases. Partly reflecting low-cost imports from Asian emerging markets and falling commodity prices, consumer price inflation in the advanced economies eased further in 1998, to 1½ percent. In a number of emerging market economies, however—including Indonesia and Russia—inflation rose sharply following currency depreciations.

Associated with the financial turmoil in emerging market economies was a precipitous drop in private capital inflows. In the wake of the Russian crisis, most emerging market borrowers temporarily lost access to private financing as interest rate spreads reached levels not observed since the Mexican crisis of 1995, with Latin American countries most affected. A general flight to quality and liquidity also prompted a severe tightening of credit conditions and a sharp fall in equity prices in developed financial markets before tensions eased in late 1998. Net private capital flows to emerging market economies fell to about $65 billion in 1998, less than one-third the peak reached in 1996 and the lowest annual level of the decade (Table 2). The Brazilian crisis postponed the return of interest rate spreads and capital flows to levels observed before the Russian crisis, but by March and April 1999 emerging market borrowers, including some in Latin America, began to return to the market.

Slower output growth in all the main country groups in 1998 led to a sharp slowdown in the growth of world trade volume to an estimated 3¼ percent, the lowest annual growth rate since 1985. Furthermore, adjustment in the crisis-afflicted emerging market economies, the more difficult external financing environment, falling prices for commodity exports, and the uneven pattern of growth among the industrial countries contributed to substantial changes in regional and national trade and payments balances. The trade balances of the crisis-afflicted East Asian economies turned sharply positive in 1998, to the tune of almost $100 billion, as the severe import compression initiated in the second half of 1997 continued. Reflecting the incipient recovery in the East Asian crisis countries, their combined trade surplus began to narrow in late 1998 and early 1999. The main adjustment effort then shifted to those Latin American countries that were confronted with a more unfavorable external environment, and to major commodity-exporting developing countries that had initially relied on reserves and external borrowing to absorb the revenue shortfall from lower commodity prices. The improvement in trade balances of the emerging market economies as a group found its counterpart mainly in a number of industrial countries, where domestic demand growth exceeded output growth—especially in the United States, which accounted for about half of the growth in world demand in 1998. The combined trade balances of the industrial countries worsened in 1998 by almost $80 billion.

Table 1Overview of the World Economy(Annual percent change unless otherwise noted)
19911992199319941995199619971998
World output1.82.72.74.03.74.34.22.5
Advanced economies1.21.91.23.22.63.23.22.2
Major industrial countries0.81.81.12.92.13.03.02.2
United States–0.92.72.33.52.33.43.93.9
Japan3.81.00.30.61.55.01.4–2.8
Germany5.02.2–1.22.71.21.32.22.8
France0.81.2–1.32.82.11.62.33.1
Italy1.10.6–1.22.22.90.91.51.4
United Kingdom–1.50.12.34.42.82.63.52.1
Canada–1.90.92.34.72.61.23.83.0
Other industrial countries2.92.52.04.64.43.84.22.1
Memorandum
Industrial countries0.81.70.92.92.33.03.02.5
Euro area2.41.3–1.02.72.31.72.52.9
Newly industrialized Asian economies7.95.86.37.67.36.36.0–1.5
Developing countries4.96.76.56.86.16.55.73.3
Africa1.80.20.72.23.15.83.13.4
Asia6.69.59.39.69.18.26.63.8
China9.214.213.512.610.59.68.87.8
India1.74.25.17.28.07.45.55.6
ASEAN-417.46.77.17.78.17.13.8–9.4
Middle East and Europe2.77.04.00.63.74.74.42.9
Western Hemisphere3.93.33.95.21.33.65.22.3
Brazil1.0–0.54.95.94.22.83.50.2
Countries in transition–7.4–11.7–6.4–7.5–1.1–0.32.2–0.2
Central and eastern Europe–9.9–8.5–3.7–2.91.61.63.12.4
Excluding Belarus and Ukraine–10.7–5.00.33.25.63.73.52.6
Russia–5.0–14.5–8.7–12.6–4.1–3.50.8–4.8
Transcaucasus and central Asia–7.0–14.4–9.6–10.4–4.41.62.42.0
World trade volume (goods and services)4.64.73.79.19.66.99.93.3
Imports
Advanced economies3.44.81.79.79.16.59.14.7
Developing countries9.711.18.77.211.58.211.2–0.7
Countries in transition–12.7–25.78.95.515.39.69.31.2
Exports
Advanced economies5.85.23.48.79.16.310.33.2
Developing countries6.210.78.213.110.59.211.42.2
Countries in transition3.6–21.38.02.811.56.66.24.1
Commodity prices in U.S. dollars
Oil2
In SDRs–16.4–4.5–11.1–7.31.823.7–0.2–31.2
In U.S. dollars–15.7–1.7–11.8–5.07.918.4–5.4–32.1
Nonfuel3
In SDRs–6.5–2.82.710.62.33.32.0–13.5
In U.S. dollars–5.70.11.813.48.4–1.2–3.3–14.8
Consumer prices
Advanced economies4.73.53.12.62.52.42.11.6
Developing countries36.538.947.251.822.214.39.410.4
Countries in transition94.1646.4602.0266.9126.940.628.220.8
Six-month LIBOR (in percent)4
On U.S. dollar deposits6.13.93.45.16.15.65.95.6
On Japanese yen deposits7.24.33.02.41.30.70.70.7
On euro deposits9.59.87.45.75.73.73.53.7
Source: IMF, World Economic Outlook (May 1999).

Indonesia, Malaysia, the Philippines, and Thailand.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil.

Average, based on world commodity export weights.

London interbank offered rate.

Source: IMF, World Economic Outlook (May 1999).

Indonesia, Malaysia, the Philippines, and Thailand.

Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil.

Average, based on world commodity export weights.

London interbank offered rate.

Figure 1World Indicators

(Annual percent change)

1Goods and services, volume.

Emerging Market Economies

Growth in the developing countries slowed to 3¼ percent in 1998 from 5¾ percent in 1997, with Africa the only region recording an increase, albeit limited, in growth (Figure 2). The East Asian crisis countries other than the Philippines suffered severe output declines.

Among the Asian crisis countries, financial markets in Korea and Thailand began to stabilize in the second quarter of 1998 and signs of a bottoming out of economic activity emerged later in the year, although output growth was negative for the year as a whole. In both countries, investor confidence strengthened significantly, allowing currencies to recover some of their losses, interest rates to fall, and equity markets to rebound. Expansionary fiscal policy also provided support for demand. Positive growth resumed in Korea in late 1998. In Thailand, output stabilized in the final months of 1998 before picking up in early 1999. The current account positions of both countries improved sharply in 1998, swinging into surpluses of 12–13 percent of GDP, ow’wg largely to deep import compression. In Indonesia, where the currency came under further downward pressure in mid-1998 amid political unrest and uncertainties about policy implementation, confidence was slower to return and high interest rates had to be maintained longer to stabilize the exchange rate; output continued to decline through the end of 1998 before showing signs of recovery in early 1999.

Table 2Emerging Market Economies: Net Capital Flows1(In billions of U.S. dollars)
19911992199319941995199619971998
Total
Net private capital flows2123.8119.3181.9152.6193.3212.1149.164.3
Net direct investment31.335.556.882.797.0115.9142.7131.0
Net portfolio investment36.951.1113.6105.641.280.866.836.7
Other net investment55.632.711.5–35.855.015.4–60.4–103.4
Net official flows36.522.320.11.826.1–0.824.441.7
Change in reserves3–61.5–51.9–75.9–66.7–120.2–109.1–61.2–34.7
Memorandum
Current account4–85.1–75.6–116.0–72.0–91.0–91.8–87.1–59.1
Africa
Net private capital flows28.96.98.74.86.87.616.310.3
Net direct investment2.01.71.93.44.25.57.66.8
Net portfolio investment–1.5–0.61.00.81.5–0.22.93.5
Other net investment8.45.85.80.71.22.35.80.0
Net official flows7.810.57.814.010.83.7–4.51.5
Change in reserves3–2.50.80.8–4.7–1.7–7.4–12.32.9
Memorandum
Current account4–7.4–10.4–11.0–11.8–16.4–5.7–6.1–18.1
Asia5
Crisis countries6
Net private capital flows226.826.631.933.262.562.4–19.7–45.3
Net direct investment6.16.36.76.58.79.512.14.9
Net portfolio investment3.45.316.58.317.020.012.6–6.5
Other net investment17.315.08.718.436.932.9–44.5–43.6
Net official flows4.42.00.60.30.74.825.022.7
Change in reserves3–8.3–18.1–20.6–6.1–18.3–13.637.7–39.1
Memorandum
Current account4–25.2–16.1–13.5–23.2–40.5–53.4–27.066.6
Other Asian emerging markets
Net private capital flows27.2–8.725.533.232.638.122.8–9.6
Net direct investment8.38.526.338.741.145.650.545.1
Net portfolio investment–2.02.64.51.1–6.1–7.5–11.8–8.8
Other net investment0.9–19.7–5.4–6.6–2.40.1–15.8–45.9
Net official flows6.58.37.95.13.85.33.35.9
Change in reserves3–31.4–7.6–17.2–47.7–26.2–42.5–46.3–9.7
Memorandum
Current account323.714.0–8.517.19.417.037.530.5
Middle East and Europe7
Net private capital flows268.635.133.715.410.16.816.726.5
Net direct investment1.20.93.93.83.72.43.32.9
Net portfolio investment22.313.521.813.69.44.14.38.8
Other net investment45.120.78.0–2.0–3.00.49.114.7
Net official flows3.9–1.32.3–1.3–1.4–0.7–1.0–2.2
Change in reserves3–3.31.2–4.8–3.6–12.7–16.2–20.4–5.3
Memorandum
Current account4–64.2–26.7–31.1–7.2–5.25.42.9–22.7
Western Hemisphere
Net private capital flows224.155.962.647.538.382.087.369.0
Net direct investment11.313.912.024.926.139.350.754.0
Net portfolio investment14.730.361.160.81.740.039.733.0
Other net investment–2.011.7–10.6–38.210.62.7–3.1–18.1
Net official flows2.7–1.70.6–4.120.6–13.7–7.81.6
Change in reserves3–17.4–22.6–21.34.2–25.5–28.3–14.617.7
Memorandum
Current account4–16.9–34.5–45.7–50.9–35.9–38.9–65.1–89.6
Countries in transition
Net private capital flows2–11.73.519.618.542.915.125.713.6
Net direct investment2.44.26.05.413.413.518.517.4
Net portfolio investment0.00.18.821.017.824.419.06.7
Other net investment–14.1–0.74.8–8.011.7–22.8–11.9–10.6
Net official flows11.14.50.9–12.2–8.5–0.29.312.2
Change in reserves31.3–5.6–12.8–8.7–35.8–1.0–5.3–1.2
Memorandum
Current account44.8–1.7–6.33.9–2.4–16.2–29.3–25.8
Source: IMF, World Economic Outlook (May 1999).

Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. Emerging markets include developing countries, countries in transition, Korea, Singapore, Taiwan Province of China, and Israel. Data for Hong Kong SAR are not available.

Because of data limitations, “Other net investment” may include some official flows.

A minus sign indicates an increase.

The difference between the current account and the sum of net private capital flows, net offical flows, and change in reserves is the capital account and errors and omissions.

Includes Korea, Singapore, and Taiwan Province of China. Data for Hong Kong SAR are not available.

Indonesia, Korea, Malaysia, the Philippines, and Thailand.

Includes Israel.

Source: IMF, World Economic Outlook (May 1999).

Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing. Emerging markets include developing countries, countries in transition, Korea, Singapore, Taiwan Province of China, and Israel. Data for Hong Kong SAR are not available.

Because of data limitations, “Other net investment” may include some official flows.

A minus sign indicates an increase.

The difference between the current account and the sum of net private capital flows, net offical flows, and change in reserves is the capital account and errors and omissions.

Includes Korea, Singapore, and Taiwan Province of China. Data for Hong Kong SAR are not available.

Indonesia, Korea, Malaysia, the Philippines, and Thailand.

Includes Israel.

In Malaysia, after a period in which the authorities had responded to financial market pressures by tightening macroeconomic policy, there was a shift in August 1998 to expansionary monetary policies, with the exchange rate pegged and capital controls introduced in September 1998; some of the controls were relaxed in early 1999. As of the end of April 1999, the decline in activity bottomed out and signs of recovery emerged. The Philippines remained less affected by the crisis, but output nevertheless fell slightly in 1998, attributable mainly to a weather-related drop in agricultural production.

In other emerging market economies in Asia, China’s real GDP grew by 7¾ percent in 1998, close to the official target of 8 percent, supported by a large increase in public investment outlays. Partly reflecting low levels of capacity utilization and a decline in import prices, consumer prices fell by about 1 percent. Activity in Hong Kong SAR, however, was hit hard by the Asian crisis, with output contracting by about 5 percent in 1998. Through the early part of 1999, activity remained weak, partly because of high real interest rates amid negative inflation and weak domestic demand. The regional crisis also affected Singapore despite its strong domestic fundamentals. Although accommodative monetary policies together with downward exchange rate adjustments limited the effects of the crisis on the economy, activity nevertheless weakened in the second half of 1998 before positive growth resumed in early 1999. Other emerging market economies in Asia proved more resilient to the financial turbulence in the region. These included India—whose economy is relatively closed—although growth failed to pick up after its slowing in 1997, partly reflecting a stalling of structural reforms and a deterioration in government finances.

The East Asian crisis contributed to increases in financing costs and declines in oil and other commodity prices that put severe pressure on emerging market economies in other regions. In Russia, structural weaknesses in the enterprise and banking sectors, persistent fiscal imbalances, and a buildup of short-term government debt (including to foreign investors) left the economy especially vulnerable, and mounting tensions in the foreign exchange and treasury bill markets led in August 1998 to a de facto devaluation and a unilateral restructuring of domestic debt. Reflecting the severe financial pressure during the run-up to the August crisis and the worsening of the overall economic situation in the postcrisis period, output declined, by 4½ percent in 1998 as a whole, and inflation accelerated to more than 100 percent on a 12-month basis in early 1999, with the currency remaining under pressure. A loss of access to private market financing following the crisis led to sharp import compression and a corresponding shift into current account surplus. Nevertheless, the authorities were forced to reschedule payment obligations on debt inherited from the former Soviet Union (see Chapter 4 for further discussion of Russian developments in 1998/99).

The Russian crisis had a strong adverse impact on economic activity in neighboring countries in transition and contributed importantly to currency depreciations in a number of them—including Ukraine—as well as further inflationary consequences. The Baltic countries were less affected; they maintained their exchange rate pegs and retained access to international capital markets, but still experienced a growth slowdown owing in part to reduced trade with, and banking sector exposure to, Russia. In the transition countries of Central and Eastern Europe, the Russian crisis had a mostly temporary impact: weakening demand in the export markets of western Europe was a more important negative influence on growth performance in late 1998 and early 1999. In the Czech Republic, in part reflecting a tightening of policies in 1997 and early 1998 that was needed to reduce external imbalances, output fell by 2¼ percent in 1998. In Hungary and Poland, growth was relatively robust, at about 5 percent in 1998, despite the year-end slowdown. Consumer price inflation in all three countries declined rapidly in late 1998 and early 1999, to single digits on a 12-month basis, reflecting falling commodity prices, past monetary policy tightening, and a weakening of economic growth.

Figure 2Developing Countries: Real GDP Growth

(Annual percent change)

In Latin America, most countries coped well with the financial pressures emanating from the Asian crisis, owing in part to actions to tighten macroeconomic policies. They were affected significantly by the Russian crisis, however, as interest rate spreads on their external debt soared and private capital inflows came to a virtual halt. Brazil came under particularly heavy pressure because of concerns about its large fiscal deficit and the sustainability of its exchange rate peg. In response, the Brazilian authorities raised official interest rates and, in late October 1998, announced a set of fiscal measures aimed at producing substantial primary surpluses, as part of a policy program supported by IMF financing. However, investor concerns about the authorities’ ability to implement these fiscal measures and fears that interest rates were insufficiently high to stop continued capital outflows resulted in increasing pressure on the currency, which led the central bank in January to abandon its crawling exchange rate band and to allow the real to float. The currency initially depreciated by more than 40 percent against the U.S. dollar and, amid widespread domestic financial market volatility, it remained under pressure until early March, when moves to strengthen the fiscal adjustment program began to restore confidence in Latin American countries generally. (See Chapter 4 for further discussion of Brazilian developments in 1998/99.)

The Brazilian devaluation had relatively limited and mostly temporary effects on financial markets in other Latin American countries but is having more significant trade-related spillover effects on Brazil’s partners in the MERCOSUR trade agreement (Argentina, Paraguay, and Uruguay). Growth in Latin America had already slowed sharply in the second half of 1998. This slowdown reflected partly the less favorable external financing environment that developed in the aftermath of the Russian crisis, but also significantly lower commodity prices, and—in most cases—tighter monetary and fiscal policies. In Argentina, after three years of vigorous recovery from the Mexican crisis, growth turned negative in the latter part of 1998, and the downturn was worsened by the trade effects of Brazil’s recession. Venezuela, hit hard by the decline in oil prices, suffered from an unsustainable fiscal situation and its recession deepened starting in the fourth quarter of 1998. In Ecuador, also heavily dependent on oil export revenues, a severe exchange rate and banking crisis erupted in February 1999. Growth was better sustained in Mexico than in most countries in South America, partly reflecting its closer links to the strongly growing U.S. economy. Elsewhere in the Western Hemisphere, the economies of several Central American countries—especially Honduras and Nicaragua—were afflicted by Hurricane Mitch in October 1998.

Economic growth in Africa remained subdued in 1998, at about 3½ percent, attributable mainly to the further weakness in commodity prices and, in South Africa where little growth was recorded, to unfavorable conditions in international financial markets. Although the effects of lower commodity prices, including oil, on the terms of trade and growth of Africa as a whole were relatively modest, fiscal positions and external accounts in many instances came under pressure, and large terms of trade losses entailed significant real income reductions. In particular, lower oil prices led to a growth slowdown in the oil-producing countries of Africa and the Middle East. Slower growth was also recorded in Turkey, where output expanded by 2¾ percent in 1998—down from 7½ percent in 1997—as contagion from the Russian crisis showed up in high real interest rates and reduced access to international financial markets. In the group of developing countries in the Middle East region and Europe, growth slowed to 3 percent in 1998 from 4½ percent in 1997, owing mainly to developments in the oil-producing countries and in Turkey.

Advanced Economies

Divergences in economic performance among the advanced economies grew more pronounced in 1998 as the recession in Japan deepened, the strengthening of growth in the euro area waned toward the end of the year, and growth continued strong in the United States.

The Japanese economy contracted by 2¾ percent in 1998, but in early 1999 output recovered sharply to a level slightly above that of early 1998, though still below the 1997 levels. Consumer prices remained broadly unchanged through the period, while prices at the wholesale level fell, contributing to concerns about deflation. The deepening of Japan’s recession in 1998 stemmed primarily from weakness in private demand, accounted for in turn by declining confidence and weaknesses in the financial sector, but also from the weakening demand in the emerging market economies of East Asia. In response, the authorities undertook additional fiscal stimulus and also eased monetary policy further, lowering a key policy rate (the overnight call rate) virtually to zero by March 1999. Moreover, to address persistent weaknesses in the financial sector, legislation was approved in October 1998 that put in place a comprehensive framework for dealing with banking problems. These measures helped boost activity and improve financial market sentiment in early 1999.

In Europe, Stage 3 of European Economic and Monetary Union began successfully on January 1, 1999, with 11 member countries of the EU adopting the euro as their currency and the European Central Bank (ECB) assuming responsibility for monetary policy in the euro area. Through 1998, short- and long-term interest rates in the area continued to converge toward the levels prevailing in Germany, France, and other core countries; in a coordinated move in early December, official short-term interest rates were lowered to 3 percent. The ECB held its repurchase (“repo”) rate at this level until early April 1999, when the rate was lowered to 2½ percent. Growth in the euro area, which had strengthened in 1997, with momentum largely maintained through mid-1998, slowed significantly in late 1998, reflecting weaker external demand and an associated deterioration in business confidence, before recovering partially in early 1999. Inflation remained well under control in the area as a whole, with 12-month consumer price inflation at 1.1 percent at the end of the period, partly reflecting weak commodity prices. Unemployment in the euro area remained high, at 10½ percent in April 1999, compared with 11 percent a year earlier.

Among the major euro-area countries, the growth slowdown in late 1998 was most apparent in Germany and Italy but less pronounced in France. France recorded above-potential growth in 1998 as a whole, but in Italy output expanded by only 1½ percent for the second successive year. Elsewhere in the euro area, Ireland (again the fastest growing economy in Europe), the Netherlands, Portugal, and Spain continued to record robust growth in 1998, despite some slowdown toward year-end. In these countries, inflation remained somewhat above the euro-area average, because of relatively strong demand pressures.

Outside the euro area, growth in the United Kingdom declined further during 1998 and in early 1999, owing to the weakening of external demand, the strength of sterling, and past fiscal and monetary tightening. Overheating was thereby forestalled. Inflation held close to the 2½ percent target in the second half of 1998 and early 1999, and official U.K. interest rates (repo rates) were lowered to 5¼ percent from 7½ percent between October and April. The deteriorating external environment also dampened growth in some of the smaller European countries, including Denmark, Norway (particularly affected by the fall in oil prices), and Switzerland.

In the United States, the economy continued to grow strongly, expanding by almost 4 percent in 1998, with domestic demand boosted by strong gains in equity prices and declines in interest rates. Vigorous employment growth cut unemployment to a 29-year low of 4¼ percent in early 1999. Net external demand, however, weakened during 1998, reflecting developments in the emerging market economies of East Asia and Latin America, as well as the strong dollar, with the effects being felt mainly in the industrial sector. During September-November 1998, monetary policy was eased in response to severe financial market pressures that emerged in the wake of the Russian crisis and the near collapse of a major hedge fund. Inflation was broadly stable, dampened by further declines in import prices and the absence of significant wage pressures. Reflecting the benefits of past fiscal adjustment and strong economic growth, the federal budget swung into a surplus of nearly 1 percent of GDP in 1998.

In Canada, economic activity slowed in 1998 as a whole as income, output, and the external balance were adversely affected by falling commodity prices and lower demand in a number of Canada’s overseas markets. The pace of growth, however, picked up again toward the end of the year. Core inflation held steady, at the lower end of the 1–3 percent official target range, despite the depreciation of the Canadian dollar during the year. Growth in Australia accelerated in 1998 despite the East Asian recessions, with demand boosted by an easing of monetary conditions, including through depreciation of the Australian dollar; strong growth continued in early 1999. In New Zealand, by contrast, the economy went into recession in the first half of 1998, but growth resumed in the second half as business and consumer confidence rebounded, supported by looser monetary policy. In both countries, annual inflation remained broadly stable, at about 1½ percent.

In foreign exchange markets, exchange rates among the major currencies were again subject to significant fluctuations in 1998/99. In mid-July 1998, the U.S. dollar reached its highest level in nominal effective terms since December 1986, buoyed by strong domestic demand growth, interest rate differentials favoring U.S. dollar-denominated assets, and safe-haven demand in the face of deteriorating sentiment toward emerging markets. The dollar’s nominal effective rate fell sharply in early September and early October, as the yen’s weakness was reversed in a large-scale unwinding of yen-denominated exposures. The dollar rebounded in late 1998 and early 1999, however, in light of the continued relative strength of the U.S. economy and an associated widening of interest differentials in favor of dollar-denominated assets. After reaching an eight-year low of more than ¥145 to the U.S. dollar in mid-June 1998, the yen appreciated in the following six months by about 25 percent against the dollar, and by 20 percent in nominal effective terms. Following an easing of Japanese monetary policy, the yen fell back by about 5 percent in effective terms in February–April 1999. During August–December 1998, the currencies of the prospective euro-area countries strengthened against the U.S. dollar, and also in effective terms. The euro itself began to depreciate shortly after its introduction; by the end of April, it was more than 9 percent below its initial value in dollar terms, and more than 6 percent lower in effective terms. Elsewhere in Europe, movements in the pound sterling were affected partly by changing expectations regarding U.K. monetary policy. Sterling traded in a relatively narrow range in 1998 but tended to depreciate in effective terms in the second half of the year. In the first part of 1999, however, sterling appreciated in effective terms as the euro weakened. Lower commodity prices contributed to downward pressure on the Canadian dollar, which depreciated to record lows against the U.S. dollar in August 1998. The currency recovered, however, following an increase in official interest rates in August 1998 and continued to appreciate while interest rates subsequently declined.

The current account balance of the industrial countries as a group deteriorated by more than $80 billion in 1998. The deterioration was unevenly distributed among the industrial countries, reflecting differences in domestic demand conditions and reliance on commodity imports and exports, as well as the strong exchange rate fluctuations among their currencies. The United States—where export growth slowed sharply but domestic demand and imports remained buoyant—accounted for the bulk of the adjustment, with the U.S. current account deficit widening by about $75 billion in 1998, to $230 billion or 2¾ percent of GDP. Japan, by contrast, recorded a further increase in its current account surplus, to 3½ percent of GDP, attributable partly to the weakness of domestic demand. In the euro area, the current account surplus of 1½ percent of GDP changed little in 1998, owing to a weakening in domestic and import demand, the competitiveness effect of past currency depreciations, and lower import prices offsetting the decline in export volumes to emerging markets. Other industrial countries—including Australia, Canada, and Norway, which all saw their commodity export revenues decline—accounted for much of the remaining adjustment.

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