The world economy seems to have now set upon a path of slow recovery. It had suffered a setback in the early 1980s, one that in some sense was the most severe recession since World War II. The volume of world trade, which had been growing at an average rate of 6 percent a year during 1976–1980, actually declined by 0.5 percent in 1981 and by a further 3 percent in 1982. There were also drastic falls in almost all other indices of global economic activity. Developed countries suffered, but the developing countries went through a period of serious crisis, with a sustained and often very significant fall in their per capita incomes. Except for a few countries in Asia, the economic conditions, living standards, and, most important, the rate of capital formation deteriorated sharply for most developing countries—those from the poorer regions of Africa as well as countries from the relatively better off regions of the Middle East and Latin America.
The recovery that started by the end of 1983 gathered some momentum in 1984, the year in which the output of the developed countries grew at about 4.7 percent, their best performance since the mid-1970s. But that growth rate had fallen to about 3 percent by the first quarter of 1985 and the latest OECD projections suggest a growth rate for all OECD countries of around 2.75 percent in 1986. In fact, most projections for the second half of 1980s indicate that developed countries are not expected to grow at an annual rate higher than 3 percent, and that the volume of world trade will grow at best at 5 to 5.5 percent a year. Clearly the recovery, if it is sustained, is going to be slow and halting. Even the most optimistic scenarios do not project a growth rate for developing countries as a whole above an average of 4.5 percent. This is a rate well below what they achieved in the 1960s and the 1970s, and one that for most developing countries will not restore, even by the end of 1990, the consumption levels they enjoyed in 1980.
Particularly disconcerting is the fact that the current economic recovery is not only slow and halting but it also seems to be rather fragile. The principal channel of transmission of this recovery, especially to developing countries, is the upswing in the volume of world trade and the expansion of the markets for the exports of developing countries. The projected growth rates of world trade in the next few years fall far short of the average annual growth rate of 7.7 percent achieved in 1967–76, but even that may be threatened by the increasing pressures for protectionism that are noticeable today.
The patterns of growth of developed countries suggested in the different scenarios are not encouraging as regards the problem of unemployment. The rate of unemployment in all industrial countries averaged about 3.5 percent during 1967–76. It increased steadily to 8.2 percent in 1984, and there is little prospect of it declining in the coming years. For Europe, it was 10.7 percent in 1984, and according to the OECD Economic Outlook, it is expected to increase to 11.25 percent by the end of 1986. This environment creates fertile ground for the growth of protectionism, to which the democratic governments of the West may be forced to succumb.
Mr, Sengupta is a member of the IMF’s Executive Board. The views expressed in this article are strictly his personal opinions and do not purport to represent the views of the Fund—Editor.
Moreover, the growth of the developed countries, on which depends the growth of exports of developing countries, itself seems uncertain. The estimates of the elasticity (or responsiveness) of non-oil developing countries’ exports with respect to the real GNP of industrial countries vary between 1.3 and 2.6, depending on the classification of exports and countries as well as the period of estimation. They all suggest that a fall in the GNP growth of developed countries may produce a significant fall in the exports of developing countries. Furthermore, an OECD study (International Economic Linkages) indicates that it may require an OECD growth rate of real GDP of 3 to 4 percent to maintain, in real terms, primary commodity prices relative to the prices of OECD export of manufactures. There is not much prospect for any improvement in capital flows to developing countries, thus the uncertainty about the growth of the industrial countries creates greater uncertainties about the growth of developing countries.
The current recovery in industrial countries seems to be closely related to the growth of the US economy and the large US current account deficits. To the extent the growth of the US economy is not dependent on US fiscal policy and budget deficits but reflects underlying real factors, such as increasing productivity, high rates of return on investment, and successful containment of inflationary expectations, the US recovery may be sustained even if the budget deficit is reduced, and the import surplus and capital inflows are significantly scaled down. However, all the medium-term projections indicate that the large current account deficit will actually expand in the next few years. The latest OECD Economic Outlook, for instance, indicates that the current account deficit will grow from $102 billion in 1984 to $151 billion by the end of 1986. It is this aspect of the near-term scenario of the international economy that makes the prospects of a sustained global recovery very uncertain.
Whatever may be the cause of the increasing current account deficit in the United States—a very large increase in the domestic expenditure compared to other OECD countries or a high dollar caused by large net capital inflows—it reflects a substantial imbalance between the value of imports and exports that is likely to become unsustainable at some point. According to some estimates, a continuation of the present scale of deficits until 1990 would lead to an accumulation of foreign debt by the United States of the order of 150 percent of the value of exports of goods and services, and would require an outflow of resources of 1.5 percent of GNP every year merely to cover interest payments after 1990. Even if, for the sake of argument, one accepts that the capital inflows to the United States are attracted by high rates of real return, and not by high interest rates, there is a limit to foreign indebtedness. After that limit is reached, foreigners may be unwilling to acquire further debt without a sharp rise in interest rates or a fall in the exchange rate. Furthermore, the perception that the market is reaching that limit will grow as the stock of net liabilities to foreigners increases, and this may create an environment of destabilizing expectation and a possible sharp fall, or “hard landing,” of the dollar. Whatever else may be the effect of this eventuality, it will almost certainly slow down the process of recovery.
Problems of debtor countries
For the developing countries, there is another highly discouraging element in these scenarios of recovery. The current account deficit of 123 indebted developing countries, which was growing steadily in the 1970s, reflecting a net absorption of resources from abroad, reached a peak of about $113 billion in 1981. Since then it has declined sharply to about $38 billion in 1984 and is expected to fall further to around $37 billion in 1986. This has taken place at a time when outflows on account of interest payments have amounted to around $82 billion a year. For the market borrowers, the current account deficits are projected to fall from $72 billion in 1981 to as low as $5.8 billion in 1986. Interest payments by these countries, which amounted to $57 billion in 1981, would, however, remain at a level of $64 billion in 1986.
Such balance of payments data indicate that from 1983 onward there has been a net resource transfer from the indebted developing countries to developed creditor countries and that transfers will continue in the coming years in the form of surpluses in trade and nonfactor services. According to one estimate, major debtors would have to generate trade surpluses amounting to 4 to 5 percent of their GDP every year well into the 1990s just to meet interest payments on their outstanding debt. A resource outflow of this order of magnitude would be difficult to maintain over a number of years without creating serious economic and social tensions.
Indeed, the problems of the indebted developing countries clearly bring out the essential features of the current international economic situation. There are misalignments, with risks of a possible sharp deterioration of output, consumption, and trade. There is also scope for coordinated international action based on mutually consistent and harmonized national policies. The total debt of developing countries increased from $610 billion in 1980 to $895 billion in 1984. Of this, as much as $472 billion is held by private lenders. Only 16 countries account for 58 percent of the total debt, 8 Latin American countries being responsible for nearly $330 billion. This high concentration of debt suggests the high vulnerability of the system to even minor changes in the conditions of lending, to economic variables affecting the value of debts outstanding, and to the debtors’ capacity to service debt.
The concentration of risk as reflected in the over-exposure of the international banks in a few countries has been the principal factor responsible for drying up of commercial bank lending to developing countries. According to the Bank for International Settlements, total net commercial bank lending in the first three quarters of 1984 amounted to only $60 billion—a drastic fall from $165 billion in 1981; of this only $10 billion went to countries outside the BIS reporting area. Most commercial banks had net inflows of funds from these countries that were re-lent to others, mainly developed countries. In the absence of any buoyancy in other sources of capital, either official flows or direct investment, or some kind of international mechanism to spread the risk, share the burden of finances, and more systematic debt rescheduling, the entire burden of sustaining debt and avoiding defaults will fall on the indebted countries. The task of meeting these burdens by debtor countries is made difficult by high interest rates and the overvalued dollar resulting from the uncoordinated macroeconomic policies of the creditor countries. A large part of these debts have been contracted at floating interest rates, and the costs of servicing them have steadily increased in the last few years. The process has been accentuated by the sharp rise in the value of the dollar (since most of these debts are denominated in dollars), while commodity prices have fallen in terms of the dollar.
While it is true that some of the problems of the debtor countries were the result of their own imprudent policies, it cannot be denied that the policies of the commercial banks and the uncoordinated international system of financial intermediation in the years of excess liquidity—the 1970s—were largely responsible for creating the basis for the current debt crisis. The problems have become critical because of the contraction of international credit markets in the early 1980s and the slow economic recovery since then. Whether they can be resolved, or at least contained, in the next few years will, again only partially, depend on the debtor countries’ own policies in carrying out adjustment programs. Other important determinants will be international factors such as the extent of the decline in interest rates, the realignment of the dollar and other major international currencies, the continued expansion of world trade, the continuation if not acceleration of the process of recovery, the containment of protectionist tendencies, and the revival of financial flows from commercial banks to debtor countries. These factors, in turn, will depend on developments in the industrial countries, policies adopted by them, how multilaterally coordinated these policies are, and how they affect the functioning of the system of international financial intermediation.
Coordination of policies
In a similar way, whether international recovery can be sustained depends only partially on the policies of individual countries following their narrowly defined national objectives. The more crucial determinants are the international consistency of these national policies, namely whether in the formulation of economic policy each country takes into account the repercussions of its own policies on others. The current recovery does not have to be slow and halting, or fragile and uncertain. In fact, it is possible to formulate internationally coordinated programs that would not only set the course of recovery on an assured path of expansion but also spread the benefits more evenly, with developing countries growing rapidly and the industrial countries maintaining a steady growth rate with price stability.
It is now generally agreed that the most important requirement for sustaining the recovery or preventing a reversal of the process would be a gradual decline in the value of the dollar, without any upward pressure on the US interest rates. It also seems that the entire international community, including the Fund, the OECD, the Group of 10, as well as the US administration believe that the most important policy action in this regard will be a reduction in the US budget deficit. Most simulation models suggest that if the budget deficits are brought down steadily through fiscal contraction, there will be a reduction in the level of activity and growth rate in the United States in the immediate future. This would exert a downward pressure on the price level and, with no change in money growth, induce a fall in interest rates. The result of lower interest rates would tend to lower the dollar, a development that would be reinforced by the reduction in domestic demand.
The immediate effect of such a scenario would be a downward pressure on the level of activity in other OECD countries through a reduction in their net exports. A large part of the growth of these countries in recent years was generated by export growth, facilitated by the rise in US imports. A reduction in the rate of expansion of the US import market, and increased competitiveness of US exports induced by a lower dollar, would adversely affect the growth of exports and GNP of Western Europe and Japan. To some extent the negative impact on their level of activity could be neutralized by a fall in their interest rate following reductions in US interest rates, with monetary growth and fiscal policy unchanged. But if, to offset the deflationary impact of the US policies, they followed a more active policy of expansion, they could allow interest rates to fall further or expenditure to increase faster, thereby picking up the slack left by the US contraction.
Clearly, if a contraction policy in the United States is coordinated with a policy of expansion in the rest of the OECD, the extent of the policy change may be contained within limits. But too sharp a reduction in the current account deficit of the United States may have an excessive impact on the level of activity in other developed countries, unless there are alternative outlets for the excess savings of most of the OECD countries. The recovery of the last few years has been characterized essentially by the absorption by the United States of excess savings of the rest of the OECD, reflected in large current account deficits in the United States accompanied by substantial surpluses in the rest of the OECD countries. If the United States reduces its level of absorption, other OECD countries would either suffer a setback in their recovery or have to follow an expansionary policy, quickly degenerating into inflation. The only way out may be for these excess savings to be invested outside OECD, mainly in developing countries. In a properly integrated international economy, therefore, policy options should not be confined to only one subset of countries.
Most of the simulations of recovery that assume a growth of GNP of the OECD countries at around 3 percent indicate no reduction in the current account deficits of the United States. These deficits remain substantial, even when the current account surplus of the rest of the OECD continues to increase. If the size of these deficits itself becomes a source of destabilizing expectation, as discussed above, by altering the perception about the limits beyond which foreigners would not be willing to hold further stock, of net liabilities, some measures would then have to be adopted to reduce these deficits without precipitating a sharp fall of the dollar or unleashing an inflationary spiral. A sharp fall in the US growth rate would, of course, bring down the deficits, but that would be a colossal waste and the worst example of noncoordination of national policies. If the United States allows a large monetary expansion to offset the effects on GNP growth of tight fiscal policy, interest rates would fall, the dollar would depreciate, current balances would improve, but prices would start rising. There would be a loss of confidence in the anti-inflationary stance of US policy, which would rekindle inflationary expectations in other OECD countries. An expansionary policy in the rest of the OECD is also limited by the fear of stimulating inflation, setting the limits beyond which their surpluses cannot be reduced. So the US deficits can be brought down without upsetting recovery or control over inflation only if the net exports, or the incremental surplus of the OECD countries taken as a whole, find a vent in the non-OECD developing countries.
Although the characteristics of the current situation and the source of surplus of the OECD countries are quite different from the situation following the first oil shock of 1973–74 that generated the surplus of the OPEC countries, it is plausible to argue that analytically the world is facing today similar problems of financial intermediation. The current account surplus of the OECD countries other than the United States is expected to increase from $44 billion in 1984 to $77 billion in 1986. It is highly unlikely that marginal changes in domestic policies would affect these surpluses in any significant manner, especially since most countries are firm on their anti-inflationary policies. A reduction in the US deficits would thus increase the net surplus of the OECD countries that cannot be absorbed within the OECD countries, just as the OPEC surplus could not be absorbed within the OPEC countries.
It therefore becomes a challenge to the international community to devise a mechanism of financial intermediation so that this surplus from the OECD countries can be effectively transferred to the developing countries which can expand their deficits and absorb them through productive investments. In the mid-1970s the international community failed to devise such a mechanism. The OPEC surplus was largely recycled to the developed countries, and the intermediation of the international banks in favor of a few developing countries in an environment of zero, or negative, real interest rates dissipated itself in unsustainable investments. That phase of international financial interaction ended with the virtual disappearance of the OPEC surplus. But the world scene today is different. The OECD surplus is not likely to disappear, and a reduction in the deficits of the United States, which may be essential for sustaining the recovery, would only heighten the need for effective intermediation.
One lesson that has been effectively learned from the recycling experience of the 1970s is that the market is a poor performer in international financial intermediation. This should not have been unexpected because that experience with financial intermediation involved investment in developing economies, and the literature on the economics of development begins with imperfections in the capital market, where the “true” rate of return on investment is not reflected in the “appropriable” market rates of return or interest. If there is any area where the total approach of development programs determines the viability of the components of the program, it is in the investment activities in tradable products, especially in the industrial sector. If the market could allocate investable surpluses optimally, underdeveloped countries would not have remained underdeveloped.
This does not mean that financial intermediation should necessarily involve subsidization. That would not be feasible, because financial intermediaries, whether they are commercial banks or international institutions, have to pay reasonable compensation to private savers who, through capital markets in industrial countries, channel their savings to developing countries. But this points to the need for planning and coordination of policies. Projects should be so chosen that they are mutually supportive, thus increasing their viability. Sometimes, a prior or simultaneous investment in infrastructure, actively supported by concessional funding, can significantly increase the commercial return of a particular investment. In other cases, the viability of even an attractive commercial project may depend on a set of policies that a government can adopt only if it has balance of payments support over the medium term, or financial resources to undertake structural adjustment over a longer term. In these instances, financial intermediation, even on commercial terms, can be more effective if properly integrated with multilateral development or balance of payments financing. Even the international banking system, which is now very reticent about lending to developing countries, can revive its activities if part of its risk is shared by the international community, either with a guarantee or through cofinancing by some international agency, or through financing of complementary projects with substantial backward and forward “linkages.”
In other words, it is possible to devise appropriate mechanisms of international financial intermediation that would channel the growing surplus of OECD industrial countries to productive and viable investment projects in the developing countries. The essential prerequisite for that is an effective coordination of national policies of the countries concerned. The need for coordination of the policies of developing countries with those of the multilateral agencies has already been noted. The viability of investment projects financed by international resources would also depend upon the developing countries’ ability to transfer investment incomes into foreign exchange, which would depend upon the growth of their exports, which in turn would be determined by the growth of the international economy and the reversal of protectionist tendencies. Indeed, the success of transferring international savings to the developing countries through financial intermediation is dependent on the process of recovery, supported by coordinated policies, and creating a basis for the world economy to grow with price stability.
This article began by noting that the current world recovery is slow and fragile. It has tried to show that the process need not be so, and that schemes could be envisaged that would sustain the growth of the world economy with stability and with benefits more evenly spread. The logic of these proposals is derived from the increasing global interdependence between the developed and developing countries. Growth scenarios, normally begin with the recovery and growth of the developed countries, leading to the growth of their imports from the developing countries, which, together with capital flows, determine the developing countries’ import capacity, and this in turn determines their rates of growth. If, according to the above reasoning, an effective system of international financial intermediation can be developed, capital flows to the developing countries could be raised substantially, pushing up the import capacity and the rate of growth of these countries. The effect of the growth of the developing countries on the rise of exports from OECD countries, and consequently on their GNP growth, has not been always fully appreciated.
The recent OECD Outlook states that the experience of 1982, “when the decline of the OECD exports to the developing countries reduced OECD GNP growth by 1 percentage point or more, suggests that the adverse impact on the OECD countries themselves could well be of macroeconomic significance.” The experience of 1982 was the result of the acute financing problems of the developing countries. If a better system of financial intermediation improves the growth of these developing countries, the positive results could be equally significant.
New from the Fund
The West African Monetary Union An Analytical Review
by Rattan J. Bhatia
Number 35 in the Occasional Paper series, this study reviews the evolution and operation of the West African Monetary Union and its Central Bank since the early 1960s. It analyzes the implementation of monetary policy in the area as an experiment in monetary integration before and after the watershed year of 1974, when the statutes of the Central Bank were revised to enhance its role. An analysis of the divergence and integration of fiscal and monetary policies in a union of developing countries.
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