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Effect of a Slowdown in Industrial Economies on Selected Asian Countries

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1986
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WITH THE SLOWDOWN of growth in industrial countries in 1985, developing countries have faced a more difficult environment in which to maintain momentum in reducing external payments imbalances, service external debt, and sustain economic growth. Although the debt-servicing burden has been eased somewhat by a reduction in interest rates, particularly those on U.S.-dollar-denominated debt, commodity prices and trade volumes in developing countries have been severely affected by the drop in industrial country growth to less than half the rate that was achieved in 1984.

The importance of the external environment for the economic performance of developing countries is stressed in several recent studies of the linkage between economic developments in industrial countries and in developing countries. In particular, on the basis of a small simulation model designed to investigate mediumterm developments in the balance of payments and the debt profiles of several developing countries, Cline (1984) has found that growth in industrial countries is the most important factor influencing current account positions and the ratios of debt to exports in developing countries. Other studies, including those by the Morgan Guaranty Trust Company (1983) and Leven and Roberts (1983), have come to the same conclusions using similar approaches. Dornbusch (1985) has adopted a different approach that examines the effects of performance in industrial countries on the welfare, measured in terms of current real income, of indebted developing countries. He has argued that developments in real interest rates in industrial countries and the terms of trade of developing countries are the critical factors affecting that welfare; industrial country growth has its main effect in its influence on the terms of trade. A third approach, adopted by Sachs and McKibbin (1985), brings out the importance of the policy mix in industrial countries for the current account and overall external position of developing countries; they have concluded that a combination of tight fiscal policy and relatively easy monetary policy is optimal for improving the external position of developing countries.

The purpose of the present paper is to examine the linkage between developments in industrial countries and the economic performance of a group of six Asian countries.1 A simple model is developed that is designed to investigate these links, taking into account developments in both the Asian countries’ external positions and their domestic economies. Furthermore, unlike earlier studies, the paper explicitly examines the function of policies in developing countries in offsetting the effects of slower industrial country growth. The specific question addressed in this study is that of how the slowdown in growth in industrial countries in 1985 has affected the current accounts, debt positions, and growth in these six Asian countries in 1985 and 1986. In particular, how much has the reduction in export market growth weakened the current account position of these countries and thereby enlarged debt and the debt service burden relative to the outcome that would have occurred if industrial country growth had been sustained at its 1984 rate? Have the negative effects of slower industrial country growth been mitigated in part by lower interest rates? Could the Asian countries have had access to financing that would have allowed external deficits larger than actually occurred or are projected to occur, or were they forced to adopt more stringent policies in order to strengthen adjustment and to contain the deterioration in their current account positions? How would easier policies in these developing countries have affected the growth of both gross national product (GNP) and domestic expenditure?

The paper addresses these questions by providing estimates of the impact of slower industrial country growth on the current account positions, debt profiles, and GNP growth rates of the six Asian countries. The estimates are derived from a simple model that determines domestic income, absorption, and the external current account. The model is simulated under various assumptions about both economic performance in industrial countries and policy reactions in the Asian countries. Specifically, the outcomes for the current account position, debt-servicing burden, and GNP growth of the six Asian countries under a low-growth and a high-growth scenario are compared. The low-growth scenario is based on the actual outcome for industrial countries in 1985 and on April 1986 World Economic Outlook (WEO) projections for 1986 (International Monetary Fund (1986)): growth of about 3 percent in both 1985 and 1986; short-term dollar interest rates of 8½ percent in 1985 and 7½ percent in 1986; a depreciation of the dollar against currencies of other industrial countries of about 3 percent in 1985 (percentage change of yearly average exchange rates) and of over 20 percent in 1986; and roughly constant dollar export unit values in industrial countries in 1985, followed by an increase of over 10 percent in 1986,2 The high-growth scenario assumes that growth in industrial countries remains at 4.7 percent, U.S. interest rates remain at over 11 percent, the depreciation of the dollar against other major currencies is about half that under the low-growth scenario, and increases in dollar export unit values in industrial countries are slightly less than in the low-growth case.3 Because the model is highly aggregated, it does not focus on many specific aspects of the six economies under study. Therefore, estimates discussed in this paper provide only rough orders of magnitude of the effects of a slowdown in industrial countries on the economies of the Asian countries.

In general, the results of the present paper point to a somewhat smaller effect from a slowing of industrial country growth on the current account positions of developing countries than found in the other studies mentioned above. This discrepancy arises mainly because other studies failed to specify as endogenous the effect of slower export growth, or of a deterioration in the terms of trade, on income and domestic demand in developing countries. This failure distorts results in two ways: first, it tends to overstate the effects of slower growth in industrial countries on the current account positions of developing countries by not accounting explicitly for the effect of slower growth of export receipts on import demand; second, it does not take into account the effects of shifts in the policy stance of developing countries in response to external changes that influence the trade-off between current account adjustment and growth. The model developed in this paper attempts to eliminate this source of possible distortion by including explicitly the influence of demand management policies on domestic absorption.

The remainder of the paper includes a description of the model (Section I), the results of the simulation (Section II), and some concluding observations (Section III).

I. The Model

The model consists of behavioral equations for variables that determine the current account position and the growth of GNP. Equations for export supplies and prices and for import demand are specified; these, together with the net service account excluding interest payments, the transfer account, and interest payments, determine the current account. GNP is the sum of net exports, net factor payments from abroad, and domestic demand (consumption plus investment of the private and public sectors). Domestic demand is postulated to grow at a rate equivalent to some proportion of real income growth; the proportion is determined by the stance of macroeconomic policies.

Before the model is described in detail, it is worth noting several characteristics particular to Asian economies that affect the sensitivity of these economies to slower growth in industrial countries. First, for Asian countries taken together, net external borrowing is assumed not to be a binding constraint—the countries as a group could finance a larger current account deficit than that resulting from the high-growth scenario. In the present model, the assumption of access to external financing is implicit in the assumption that the authorities can use discretion in determining the extent to which domestic demand adjusts to changes in income growth; the lesser is the adjustment, the greater is the deterioration in the current account following the slowdown in foreign growth. Were it assumed that net external borrowing did impose a binding constraint on the current account, the adjustment of domestic demand to the slowdown in income growth would have to be immediate. In that case, financial policies would have to be tightened sufficiently to contain absorption and thus would reduce imports by the same amount as the decline in exports.4

Second, the experience of Asian countries suggests that, in the short term, GNP growth is largely demand-determined; in general, the GNP growth rate immediately reflects disturbances such as a slowdown in foreign demand for Asian exports. The alternative of assuming that rapid price adjustments would maintain the growth of demand at the rate of growth of capacity would imply a weaker impact of a slowdown in external demand on Asian GNP growth.5 The present approach, therefore, is not suitable for a long-run analysis because of its scant attention to supply-side considerations.

The model is presented in Table 1. A single model was applied to the six Asian countries together, so that each equation should be regarded as a weighted average of that equation for each country. Definitions of the symbols used appear in Table 2; variables expressed in value terms are given in U.S. dollars. For ease of presentation, the model is written in level form, but it is simulated in percentage-change form (first difference of logarithms).

The Asian countries are characterized as producers of four types of goods—manufactured goods for export, primary commodities for export, oil for both domestic consumption and export, and nontraded goods.6 The first two groups of equations in Table 1 describe the output and prices of exports, which are assumed to be imperfect substitutes for one another and for non-traded goods. There are three types of exports. The first, manufactured exports, is assumed to be imperfectly substitutable for manufactured goods produced outside the region; Asian countries have some monopolistic power in setting the price of these goods. Equation (la) describes the demand for manufactured exports as a function of their price relative to the price level in industrial countries, expressed in local currency, and of demand in industrial countries. The supply of manufactured exports is a function of production capacity and of the price of manufactured goods relative to the price of goods substitutable for the manufactures in production—that is, primary commodities and nontraded goods. Because supply is assumed to respond to price incentives with a lag, the price term is an average of the relative prices in the current and the previous periods. Combining these two equations produces the reduced forms (la′) and (lb′) for the quantity and price of manufactured exports.

Table 1.Summary of the Model
Equation

Number
Equation
Exports of manufactures
(la)xNd=a0+a1(pwx+epN)+a2yw
(lb)xNs=a3+a4[(pNpst)/2+(pN,t1ps1,t1)/2]+a5y*
Reduced form:
(la′)xN=a0+a1[Pwx+e(ps1+ps1,t1)/2+pN,t1]+a2yw+a3y*
(lb′)pN=a4+a5[(ps1+ps1,t1)/2+pN,t1]+a6(pwx+e)+a7ywa8y*
Exports of primary commodities
(2a)pC=b1T+b2yW+b3yW,t1+b4(pWx)+PCDUM
(2b)xC=b5T+b6[(pc+pc,t1)/2(ps2,t1)/2]
Imports
(3a)m=c0c1(pMpA)+c2abs+MDUM
(3b)pM=c3pWm+c4pc+(1c3c4)po
Services and transfers account of the balance of payments
(4a)NS=Xs+WR+i1[(R+Rt1)/2]+OTMsi2(Z+Zt1)/2DIR
(4b)Xs=0.17(PNXN+PcXc+PoXo)
(4c)Ms=0.27(PMM)
Domestic pricesa
(5a)Nd=ABSM
(5b)ns=d1[(pD+pD,t1)/2(pT+pT,t1)/2(e+et1)/2]+d2yD*
Reduced form:
(5a′)pD=do+d1(abs)d2md3yD*+pTpD,t1
(5c)pY=w1pN+w2(pC+e)+w3(pO+e)+(1w1w2w3)pD
(5d)pA=w4(pWm+e)+w5(pO+e)+w6(pc+e)+(1w4w5w6)pD
Income and absorption
(6a)abs=K+gyR
(6b)yR=y+pYpA
Official reserves, current account.

debt, and gross national product (GNP)
(7a)R=3.3(MPM/12)Rt1(0.25eW)
(7b)CAPNXN+PCXC+POXOPMM+NS
(7c)Z[(Zt1CADI+RRt1)(1+0.25ew)](10.2ew)
(7d)YABS+XN+XC+XO+NS/PYM
Pricesb and interest rates
(8a)ps10.08(pc+e)+0.92pD
(8b)ps20.14(pne)+0.86(pde)
(8c)pT0.41(pNe)+0.59pc
(8d)i10.75ius+0.25ij
(8e)i20.56[0.8(ius+0.005)+0.2ij]+0.44iF
Note: Symbols are defined in Table 2. Lowercase letters denote logarithms of variables. Superscript d denotes demand, superscript s supply. All symbols denote data for the current time period unless a subscript indicates otherwise.

To derive the reduced-form equation for prices of nontraded goods, equation (5a) is expressed in logarithmic terms.

The price indices (equations (8a-c)) are constructed specifically to represent the prices of goods that are alternatives in production to other non-oil goods: ps1 is the price of alternatives to manufactured exports; ps2 is the price of alternatives to primary commodities; and pτ is the price of alternatives to nontraded goods. For each index, the weights reflect the shares of the two substitute goods in total non-oil output in each country and the share of each country in total production of the good described in the relevant supply equation. Thus, the index of prices of goods substitutable in production for commodity K is Σcj(Σωijpi), where cj (j Ó 1,…, 6) is the share of the j th country in the total production by the six Asian countries of commodity K, and ωij (i = 1, 2) is the share of commodity i in the total non-oil production of countryj.

Note: Symbols are defined in Table 2. Lowercase letters denote logarithms of variables. Superscript d denotes demand, superscript s supply. All symbols denote data for the current time period unless a subscript indicates otherwise.

To derive the reduced-form equation for prices of nontraded goods, equation (5a) is expressed in logarithmic terms.

The price indices (equations (8a-c)) are constructed specifically to represent the prices of goods that are alternatives in production to other non-oil goods: ps1 is the price of alternatives to manufactured exports; ps2 is the price of alternatives to primary commodities; and pτ is the price of alternatives to nontraded goods. For each index, the weights reflect the shares of the two substitute goods in total non-oil output in each country and the share of each country in total production of the good described in the relevant supply equation. Thus, the index of prices of goods substitutable in production for commodity K is Σcj(Σωijpi), where cj (j Ó 1,…, 6) is the share of the j th country in the total production by the six Asian countries of commodity K, and ωij (i = 1, 2) is the share of commodity i in the total non-oil production of countryj.

Table 2.Key to Symbols Used
SymbolDefinition
Endogenous variables
XNVolume of manufactured exports
pNAsian currency price of manufactured exports
XCVolume of primary commodity exports excluding oil and liquefied natural
gas (LNG)
PCU.S. dollar price of primary commodity exports excluding oil and LNG
MVolume of total imports
PMDollar price of total imports
XsReceipts from nonfactor services
MsPayments for nonfactor services
NSNet services and transfers
YReal GNP
ABSReal domestic absorption
YRReal income
NReal value of nontraded goods
PYGNP deflator expressed in Asian currencies
PAAbsorption deflator expressed in Asian currencies
PDDeflator for nontraded goods
ZExternal debt at the beginning of the period
CAExternal current account in dollars
ROfficial holdings of foreign exchange reserves
Exogenous variables
PWxExport unit values in industrial countries weighted by the share of the
Asian countries’ exports to each industrial country
PWmExport unit values in industrial countries weighted by the share of each
country’s exports in the Asian countries’ imports
YWReal GNP in industrial countries
iusDollar interest rate
ijInterest rate on assets or liabilities in nondollar currencies
iFInterest rate on fixed-rate debt (= 0.052)
XoVolume of oil and LNG exports
PoDollar price of oil and LNG
Y*Capacity output for manufactured exports
TTime trend
WRWorkers’ remittances
OTOfficial transfers
DIRRemittances for direct investment
DIDirect foreign investment
EExchange rate (Asian currency units per U.S. dollar)
EwExchange rate between dollar and weighted average of other major cur-
rencies (currency units per dollar)
PFAPrivately held foreign assets (assumed to have same currency composition
as official reserves)
YD*Capacity output for nontraded goods
PCDUMDummy variable to capture decline in primary commodity prices in 1985
MDUMDummy variable to capture weakness of import volume in 1985 and 1986

The second type of export, non-oil primary commodities, is assumed to be a perfect substitute for goods produced outside the region. Because Asian countries are relatively small producers of non-oil primary commodities, the dollar price of these commodities (equation (2a)) is determined exclusively by foreign variables—output in industrial countries and the price level in industrial countries. The supply of primary commodity exports by Asian countries (equation (2b)) grows with a trend and responds to shifts in the world price of primary commodities relative to goods substitutable in production for primary commodities. As for manufactured goods, supply is assumed to respond to price incentives with a lag, so that the price term is an average of the relative prices in the current and the previous periods. The third type of export is oil (and liquefied natural gas), both the price and output of which are exogenously determined.

The quantity of imports (equation (3a)), both oil and non-oil, is determined by domestic absorption and the price of imports relative to the absorption deflator. The price of imports is an average of prices in industrial countries, primary commodity prices, and the oil price that is weighted by the share of these goods in imports. A dummy variable, MDUM, is included to capture the unusually sharp drop in imports in 1985, which is assumed to continue in 1986 because of import restrictions.

On the services and transfers account, nonfactor service receipts are assumed to be fixed in proportion to the value of total merchandise exports. Similarly, nonfactor service payments are assumed to be fixed in proportion to the value of merchandise imports. Workers’ remittances, remittances on direct investment, and official transfers are exogenously determined. Equations (4a–c) show the overall balance on the services and transfers account.

The price of nontraded goods is assumed to adjust so as to equilibrate the supply and demand for these goods. Equation (5a) defines the demand for nontraded goods as the difference between absorption and imports, and equation (5b) specifies the supply of nontraded goods as a function of their price relative to the price of traded goods and of production capacity. As with the equations for prices of manufactured goods and primary commodities, the relative price term is an average of prices in the present and previous periods. Equation (5a′) is the reduced-form equation for the price of nontraded goods. The GNP deflator (equation (5c)) is a weighted average (according to production shares) of the three types of exports and nontraded goods, expressed in terms of a weighted average of domestic currencies. The deflator for absorption (equation (5d)) is a weighted average (according to absorption shares) of imports and the price of non-traded goods, also expressed in terms of domestic currencies.

The absorption equation (6a) plays a central role in determining the effect of a slowdown in the growth of export receipts on both the current account position and the rates of output and absorption growth of Asian countries. The equation is specified to capture in the simplest way possible the role of demand management policies in determining the effect of a deceleration in real income growth (owing to a slowdown in export growth or to a deterioration in the terms of trade) on the growth of domestic absorption. Absorption is assumed to be related by parameter g to real income, which is defined as GNP adjusted for the effect of changes in the terms of trade. In the long run, g must be fixed at a value of or close to unity if the current account is to be maintained in balance or in a sustainable position. In the short run, however, the value of g can be altered by the stance of macroeconomic policies; a low value of g implies relatively tight policies that constrain the amount of real income that is absorbed through expenditure. Easier macroeconomic policies, in contrast, are reflected in a value of g that is close to or even greater than unity.

Gross official holdings of foreign exchange reserves (equation (7a)) are assumed to be adj usted so as to maintain an import cover of reserves, excluding current revaluation effects, equivalent to about 3.3 months of imports—the actual value in 1985 (International Monetary Fund, International Financial Statistics (various issues)). In addition, because about 25 percent of the Asian countries’ reserves are held in major currencies other than the U.S. dollar, the dollar value of reserves is affected by changes in the value of the dollar relative to other major currencies. Equation (7b) defines the current account as the difference between the value of exports and the value of imports plus net services and transfers.

Equation (7c) expresses external debt at the end of the period as debt at the end of the previous period plus the current account deficit less direct foreign investment inflows plus the desired accumulation of official foreign exchange reserves, all in the current period. Moreover, it is assumed that about 20 percent of debt is denominated in major currencies other than the dollar. The dollar value of such holdings therefore varies with changes in the exchange rate between the dollar and these other major currencies. On the basis of a breakdown of debt by characteristic provided by the World Bank (1985), it is assumed that 44 percent of total debt bears a fixed interest rate of 5.2 percent; of the remaining 56 percent, it is assumed that 80 percent bears a rate equivalent to the London interbank offered rate plus ½. percent and that 20 percent bears the average interest rate in other major industrial countries. For the purpose of calculating debt service, the shares of both fixed-rate and floating-rate debt, as well as of long-term and short-term debt, are assumed to remain at their 1984 levels. Equation (7d) defines GNP as absorption plus exports plus net services and transfers inflows less imports. The remaining equations define prices and interest rates used throughout the model.

The values of the parameters used in the simulations, given in Table 3, are drawn from various studies of Asian economies. For the equations for manufactured export volume and prices, the import demand equation, and the equation for prices of non-traded goods, parameter values are representative of estimates by Aghevli and Khan (1980) for India, the Republic of Korea, and the Philippines and by Lipschitz (1984) for the Republic of Korea. Estimates of the parameters in the equations for non-oil primary commodity prices are taken from Chu and Morrison (1984). The supply elasticity for primary commodities is an average value for a variety of commodities that were covered by Askari and Cummings (1977).

The outcome of the simulations is sensitive to the assumptions about the stance of demand management policies in the Asian countries, assumptions that are in turn reflected in the joint assumptions about the value of g and the behavior of the exchange rate between the weighted average of the six Asian currencies and the U.S. dollar.7 These latter assumptions are made jointly in order to capture the relationships among fiscal, monetary, and exchange rate policies. In the simulations, therefore, relatively tight policies take the form of a relatively low value of g, implying restrictive budgetary policies and a slow growth of credit that is meant to ensure the effectiveness of a depreciation of the domestic currency.

Table 3.Parameter Values
ParameterValueParameterValue
Exportsa
a10.49b10.12
a21.02b20.90
a30.94b30.60
a50.25b40.70
a60.75b50.04
a71.50b60.30
a80.47
Imports
c10.90
c21.10
c30.70
c40.12
Domestic pricesa
d10.20w10.10
d20.06w20.05
d33.20w30.07
w40.20
w50.06
w60.02
Absorption
g0.60
Sources: Author’s calculations, with reference to Aghevli and Khan (1980), Lipschitz (1984), Chu and Morrison (1984). Askari and Cummings (1977).

Note that a0, a4, and d0 drop out when the equations are expressed in rate-of-change form.

Sources: Author’s calculations, with reference to Aghevli and Khan (1980), Lipschitz (1984), Chu and Morrison (1984). Askari and Cummings (1977).

Note that a0, a4, and d0 drop out when the equations are expressed in rate-of-change form.

For the base case to which various simulations are compared, the value of g is set at 0.6 on the basis of calculations of its actual value in 1985. The weighted average of the six Asian currencies is assumed to depreciate against the dollar by just under 9 percent in both 1985 and 1986—the actual depreciation in 1985.8 This value for g and this assumption about exchange rate behavior reflect a considerable tightening of demand management policies relative to 1984, when the value of g is calculated to have been around 0.8 and the weighted average exchange rate depreciated in nominal terms by about 9 percent. Moreover, a value for g as low as 0.6 is unusual during a cyclical downturn in output growth, when policies have typically been relaxed to offset the impact of lower export earnings on incomes and absorption. In the simulation that investigates the outcome under easier macroeconomic policies, g is set at 0.8, and the nominal exchange rate assumption remains the same. In effect, it is therefore assumed that policies are not as supportive of the depreciation, so that the real depreciation is considerably less.

In principle the model should incorporate the effects of slower growth in the industrial countries on other critical variables in these countries (in particular, interest rates, exchange rates, and prices). In practice, inclusion of such effects would require a considerable extension of the scope and complexity of the exercise. A partial approach has therefore been adopted, in which the effects of changes in industrial country growth, interest rates, and inflation and in the value of the dollar relative to the currencies of other industrial countries are investigated both jointly and individually.

The model examines only the first-round effects of the slowdown in industrial economies. That is, the effects of slower external growth on export prices and volumes are considered, but the second-round effects of these price and volume changes on demand in industrial countries are ignored. These subsequent effects would obviously tend to mitigate the slowdown in external growth, although probably over a longer period of time than considered here.

II. Simulation Results

The simulations have been run on a yearly basis for the period 1985–86, using actual 1984 data as a starting point. Table 4 summarizes the assumptions about the key exogenous variables in the industrial countries, in the Asian countries themselves, and in the oil market. Two sets of assumptions are shown, and the results of the simulations are reported as deviations of the results of the low-growth scenario from those of the high-growth scenario.

Table 4.Assumptions for Exogenous Variables in the Simulations(Percentage change unless otherwise indicated)
Exchange Rate and Inflation
GrowthaExchangeIncreaseIncrease
Capacity forratein exportin export
producingbetweenunitunit
manufacturedInterest RatesU.S. dollarvalues ofvalues ofOil and Oil-Related
Industrialexport goodsOtherand otherindustrialcompetitorVolume
countryin AsianUnitedindustrialmajorcountriesecountriese

Oilof oilWorkers’
YearGNPcountriesaStatesbcountriesccurrenciesd(PWx)(PWx)pricefexportsremtttancesg
High-growth case
19844.77.011.37.9100.0-0.6-0.6-3.05.6
19854.77.011.37.990.0-0.8-0.87.05.6
19864.77.011.37.987.88.510.8-25.08.55.6
Low-growth case (based on actual 1985 outcome and 1986 projections)
19844.77.011.37.9100.0-0.6-0.6-3.05.6
19852.85.08.67.379.8-0.8-4.24.35.5
19863.05.07.56.575.711.310.8-36.96.05.0
Source: World Economic Outlook (WEO) (International Monetary Fund (1986)) and author’s calculations.

The values used for capacity growth of both manufactured and nontraded goods reflect the author’s assumptions; comparable data for 1985 and projections for 1986 are not available in the WEO. Capacity for producing nontraded goods is assumed to remain constant through 1986.

Six-month London interbank offered rate on U.S. dollar deposits.

Average of interest rates in other major industrial countries weighted by currency shares in the Asian countries’ debt.

Index of the exchange rates between the dollar and other major currencies expressed as foreign currency units per dollar, end of period (1984 = 100).

In terms of dollars.

Assumptions for the low-growth case differ slightly from the WEO projections because of specific characteristics of the oil exporting countries (Indonesia and Malaysia) included in the simulation.

In billions of dollars.

Source: World Economic Outlook (WEO) (International Monetary Fund (1986)) and author’s calculations.

The values used for capacity growth of both manufactured and nontraded goods reflect the author’s assumptions; comparable data for 1985 and projections for 1986 are not available in the WEO. Capacity for producing nontraded goods is assumed to remain constant through 1986.

Six-month London interbank offered rate on U.S. dollar deposits.

Average of interest rates in other major industrial countries weighted by currency shares in the Asian countries’ debt.

Index of the exchange rates between the dollar and other major currencies expressed as foreign currency units per dollar, end of period (1984 = 100).

In terms of dollars.

Assumptions for the low-growth case differ slightly from the WEO projections because of specific characteristics of the oil exporting countries (Indonesia and Malaysia) included in the simulation.

In billions of dollars.

To the extent possible, the assumptions in the high-growth case reflect a continuation of developments during 1984, whereas those in the low-growth case are based on the actual outcome for 1985 and April 1986 WEO projections for 1986 (International Monetary Fund (1986)). For some variables, notably exchange rates between major currencies and oil prices and volumes, however, behavior that was unchanged from 1984 is clearly not plausible. For these variables, assumption of a reasonable outcome for 1985 and 1986 took into account changes from the 1984 outcome—in particular, the large depreciation of the dollar in 1985 and the sharp drop in oil prices in 1986—that were considered not to be dependent on current developments in other variables. Nevertheless, without a model that would systematically relate GNP, price, and interest rate developments in industrial countries as well as oil market developments, the relationships among the assumptions used in the high-growth case are necessarily highly approximate. Insofar as the simulations are meant to illustrate the general effects of a slowdown in industrial countries, however, the specific assumptions used are not critical.

In the high-growth case, GNP growth in industrial countries is assumed to remain at its 1984 rate of 4.7 percent, whereas in the low-growth case it is assumed to fall to 2.8 percent in 1985 and then to rise slightly, to 3.0 percent, in 1986.9 For the choice of the assumptions about prices, exchange rates, and interest rates, it is important that the actual reduction in average industrial country growth in 1985 reflected mainly a slowdown in the United States, whereas growth in other industrial countries was similar to that in 1984, Data on production capacity growth in the Asian countries are not available, so the assumptions used in the model are plausible, but hypothetical, examples of such growth. Corresponding to the decline in growth in industrial countries and to the implied slowdown in export growth, the growth of capacity for producing manufactured export goods in the Asian countries is assumed to drop by 2 percentage points, from 7 percent in 1984 to 5 percent in 1985 and 1986.10 The growth of capacity for producing nontraded goods is assumed to be unchanged through 1986 in both the high- and low-growth cases.

Interest rates in industrial countries are assumed to remain at their average 1984 levels—11.3 percent for dollars and 7.9 percent for other major currencies—in the high-growth case but to fall in both 1985 and 1986 in the low-growth case. For the low-growth case, the steeper decline of dollar interest rates compared with the average of other interest rates reflects the fact that the slowdown in growth originated in the United States.

The assumptions about the exchange rate between the dollar and other industrial country currencies and about the increase in dollar-denominated export unit values in industrial countries are closely related. Specifically, insofar as industrial countries are assumed to set export prices in their own currencies, an appreciation of other currencies against the dollar tends to raise the average level of export unit values denominated in dollars.11 In the high-growth scenario, the end-of-period value of the dollar is assumed to depreciate in 1985 and 1986 by about half the amount assumed in the low-growth case, which itself reflects the actual depreciation of the dollar for 1985 and the depreciation implied by rates frozen at March 1986 values. Implicitly, therefore, it is assumed that part of the rapid depreciation of the dollar during 1985 and early 1986 was related to the weakening of growth in the United States relative to that in other industrial countries; another part, however, reflected fundamental changes in exchange market sentiments related, for example, to underlying developments in portfolios.

Export unit values in the low-growth case, which again are drawn from the WEO, are assumed to fall slightly in 1985 before rising sharply in 1986 as a result of the appreciation of other currencies against the dollar.12 In the high-growth case, export unit values are assumed to be identical to those of the low-growth case in 1985 but to increase in 1986 by about 3 percentage points less than in the low-growth case. The implication is that inflation in domestic currency terms would be about 2 percentage points higher in the high-growth case than in the low-growth case, but that the smaller appreciation of other currencies against the dollar in the high-growth case would fully offset the higher rate of inflation in 1985 and more than offset it in 1986.

The weakening in oil market conditions, particularly in early 1986, is also assumed to be related only in part to the actual drop in industrial country growth in 1985. Much of the weakening is assumed to have been unavoidable for the range of economic outcomes considered in the simulations. Thus, whereas actual developments in 1985 and the April 1986 WEO projections for oil prices and oil export volumes from the Asian countries are incorporated in the low-growth case, both oil prices and export volumes are assumed to be only a little stronger than these values in the high-growth case. Because an important share of workers’ remittances comes from workers in oil producing countries, workers’ remittances are assumed to drop by about 12 percent over the period in the low-growth case relative to the high-growth case.

The simulation results (Table 5) indicate that, under a tightening of demand management policies in Asian countries broadly consistent with that actually observed in 1985, a slowdown in growth in industrial countries—even if accompanied by an easing of interest rates, a lowering of inflation in industrial countries and a depreciation of the dollar, and weaker oil market conditions— would worsen the current account position and lower growth in Asian countries relative to the outcome of the high-growth scenario. The shift from the high-growth to the low-growth scenario widens the current account deficit by US$1 billion (as a percentage of GNP, by 0.3 percentage point) in 1985 and by $3.8 billion (as a percentage of GNP, by 0.7 percentage point) in 1986 and reduces GNP growth by about half a percentage point in 1985 and in 1986. Although lower interest rates on the existing stock of debt initially improve the debt service ratio by more than half a percentage point in the low-growth case relative to the high-growth case, the higher level of debt associated with the larger current account deficits erodes this improvement by 1986, when the debt service ratio is about the same in the two scenarios. Lower growth in industrial countries, however, unambiguously improves price performance; the rate of increase of the domestic absorption deflator in the low-growth scenario is over 1.5 percentage points less than that in the high-growth scenario in 1985 and almost 1.0 percentage point less in 1986.

These results can be put in perspective by relating them to the actual outcome for 1985 and the April 1986 WEO forecasts for 1986. The current account deficit for the six Asian countries was about $7.5 billion (about 1.6 percent of GNP) in 1985 and, in the April 1986 WEO projections, is forecast to rise to about $9.0 billion (just under 2 percent of GNP) in 1986; the debt service ratio was about 21.0 percent in 1985 and is expected to rise to about 23.5 percent in 1986. GNP growth fell to about 3.0 percent in 1985 and is projected to rise to about 3.5 percent in 1986. With these developments used as a base, the simulations indicate that under the high-growth scenario the current account deficit would have fallen to about $6.5 billion in 1985 and would fall to about $5.0 billion in 1986; the debt service ratio would have fallen to about 20.6 percent in 1985 but would have risen to about 23.5 percent in 1986, and GNP growth would have been slightly over 3.5 percent in 1985 and about 4.0 percent in 1986.13

Table 5.Difference Between Simulation Results for Low- and High-Growth Scenarios Under Restrictive Financial Policies in Asian Countries
Economic Indicator19851986
CA / GNP-0.3-0.7
CAa-1.0-3.8
Export volume growth-2.1-1.6
Import volume growth-1.5-1.8
Terms of tradeb-1.6-3.8
Debt service ratioc0.7
Debt / exports12.620.5
GNP growth-0.4-0.5
Absorption growth-0.5-0.7
Real income growth-0.8-1.2
Inflationd-1.6-0.7
Note: The results are reported as the difference between the outcomes for the low- and high-growth scenarios. Tight financial policies (g =0.6) and an 8.6 percent nominal depreciation of an export-weighted average of the Asian currencies against the dollar in both 1985 and 1986 are assumed; percentage-point differences are shown except where otherwise indicated.

In billions of dollars.

Index-point differential (1984= 100).

Ratio of total debt service payments to receipts from exports of goods and services.

Absorption deflator.

Note: The results are reported as the difference between the outcomes for the low- and high-growth scenarios. Tight financial policies (g =0.6) and an 8.6 percent nominal depreciation of an export-weighted average of the Asian currencies against the dollar in both 1985 and 1986 are assumed; percentage-point differences are shown except where otherwise indicated.

In billions of dollars.

Index-point differential (1984= 100).

Ratio of total debt service payments to receipts from exports of goods and services.

Absorption deflator.

To get a better understanding of the linkage between industrial and developing countries, it is useful to trace the channels by which a slowdown in growth in industrial countries affects the Asian countries. The primary direct effect arises from lower growth in the export receipts of the Asian countries. Because of a dampening of both export volume growth and export price increases, the growth of total export receipts drops by about 4.5 percentage points in 1985 in the low-growth scenario relative to the high-growth scenario. These changes produce secondary effects: a lowering of the growth of real income (by almost a percentage point in 1985 and by more than a percentage point in 1986) and, consequently, reductions in the growth of absorption (by half a percentage point in 1985 and by just over that in 1986) and in the growth of import volume (by about 1.5 percentage points in 1985 and almost 2.0 percentage points in 1986). The reduction in import growth is not sufficient, however, to prevent a significant deterioration in the current account position. The larger current account deficit raises indebtedness; by 1986 the higher debt is enough to offset the effect of the lower interest rate on the debt service ratio.

The weakening of the current account position and the GNP growth rate of the Asian countries in the low-growth case relative to the high-growth case reflects in large part the detrimental effects of slower growth in the industrial countries dominating the beneficial effects of lower interest rates. The influence of the other two sets of changes—lower inflation in industrial countries and a depreciation in the value of the dollar against other major currencies, on the one hand, and the weakening in oil market developments, on the other—have broadly offsetting effects on current account position and GNP growth.

Table 6 illustrates the relative magnitudes of the individual control variables on performance in the Asian countries in 1985 and 1986. The table provides the partial effects of (1) lower growth in industrial countries and lower manufactured export capacity growth in Asian countries, as well as (2) a decline in industrial country interest rates; in addition, effects of (3) a lowering of inflation in industrial countries and a depreciation of the dollar against other major currencies, as well as (4) a weakening in oil market conditions, are shown. In each of the four cases, a simulation was run with one grouping of control variables set at the values in the low-growth scenario and with all other variables remaining at the values in the high-growth scenarios. Table 6 shows the differences between the outcome from these simulations and that from the simulation under the high-growth scenario.

Table 6.Effects of Individual Changes in Control Variables
Lower Growth in

Industrial Countries and

Lower Growth of

Production Capacity

in Asian Countries
Lower Interest

Rates in

Industrial Countries
Actual Appreciation

of Major Currencies

Against the Dollar and

Drop in Inflation in

Industrial Countries
Actual Reduction

in Oil Prices and

Oil Volumes and

Related Reduction in

Workers’ Remittances
Economic Indicator19851986198519861985198619851986
CA / GNP-0.3-0.80.20.30.1-0.1-0.2
CAa-1.4-4.21.01.3-0.10.4-0.5-1.4
Export volume growth-1.5-1.7-0.10.3-0.4-0.2
Import volume growth-1.7-1.70.50.2-0.1-0.4-0.2
Terms of tradeb-l.5-2.80.1-0.3-0.2-0.8
Debt service ratioc0.71.7-1.8-2.50.20.10.30.8
Debt / exports5.713.0-0.64.01.42.45.8
GNP growth-0.4-0.60.30.30.3-0.2-0.5
Absorption growth-0.5-0.60.20.20.1-0.2-0.4
Real income growth-0.8-1.00.40.30.2-0.3-0.7
Inflationd-1.2-1.10.31.8-0.7-1.4
Note: The results are reported as the difference between the outcome for the simulations when the specified group of control variables reflects the low-growth assumptions (but all other control variables conform to the high-growth assumptions) and the outcome when all control variables conform to the high-growth assumptions. Tight financial policies in Asian countries (g =0.6) and an 8.6 percent nominal depreciation of an export-weighted average of the Asian currencies against the dollar in both 1985 and 1986 are assumed; percentage-point differences are shown except where otherwise indicated.

In billions of dollars.

Index-point differential (1984 = 100).

Ratio of total debt service payments to receipts from exports of goods and services.

Absorption deflator.

Note: The results are reported as the difference between the outcome for the simulations when the specified group of control variables reflects the low-growth assumptions (but all other control variables conform to the high-growth assumptions) and the outcome when all control variables conform to the high-growth assumptions. Tight financial policies in Asian countries (g =0.6) and an 8.6 percent nominal depreciation of an export-weighted average of the Asian currencies against the dollar in both 1985 and 1986 are assumed; percentage-point differences are shown except where otherwise indicated.

In billions of dollars.

Index-point differential (1984 = 100).

Ratio of total debt service payments to receipts from exports of goods and services.

Absorption deflator.

It is evident that lower growth in industrial countries is the main influence behind the deterioration in both the current account position and GNP growth in the low-growth scenario. For both variables, the outcome when a slowdown in industrial country growth and the corresponding reduction in capacity growth of manufactured exports are considered by themselves is quite similar to the outcome in the overall low-growth scenario. The current account deficit as a proportion of GNP worsens by 0.3 percentage point in 1985 and by almost 1.0 percentage point in 1986; owing to the enlargement in debt and weakening in exports, the debt service ratio rises by 0.7 percentage point in 1985 and by 1.7 percentage points in 1986. Downward pressure on export volume growth, together with a sizable deterioration in the terms of trade related to weaker prices of both primary commodities and manufactured goods, weakens real income growth by about a percentage point in each year. Both absorption growth and GNP growth weaken by about half a percentage point in each year.

In contrast, the effects of the individual changes in the other control variables are in general smaller than the effects of slower industrial country growth alone. The decline in industrial country interest rates and, to a lesser extent, the combination of lower inflation in industrial countries and a larger appreciation of major currencies against the dollar exert positive influences on both the current account position and GNP growth in the Asian countries. These influences therefore go some way toward offsetting the effects of lower industrial country growth and the weakening of oil market conditions in the simulation results shown in Table 5. Table 6 shows that the average differential of 3 percentage points between U.S. interest rates and the average differential of 1 percentage point between interest rates in other major countries in the high- and low-growth cases lead to an improvement in the current account of $1.0 billion in 1985 and $1.3 billion in 1986. These effects reflect entirely the lower interest payments on external debt and the related strengthening in the growth of both real income and absorption. Indeed, the improvement in the current account position is dampened slightly by higher import volume growth. The debt service ratio is lowered by almost 2.0 percentage points in 1985 and by about 2.5 percentage points in 1986—in 1985 more than offsetting the increase from changes in the other control variables and in 1986 matching that increase.

The effects of the larger appreciation of major currencies against the dollar together with lower inflation in industrial countries are quite small in 1985 when the effect of the larger exchange rate change on dollar export unit values of industrial countries is offset by the lower inflation rates in domestic currency terms. In 1985, therefore, the principal influence is the revaluation of debt and debt service payments measured in dollars. In 1986, however, the larger appreciation more than offsets the lower inflation in domestic currency terms, so that dollar export unit values are about 3 percentage points higher. The implied improvement in competitiveness of Asian countries boosts export volume growth and dampens import volume growth. Although the terms of trade deteriorate slightly because dollar prices of the Asian countries’ manufactured exports do not rise by the full extent of the increase in industrial countries’ dollar export unit values, the current account improves by about $400 million. GNP growth is higher by nearly half a percentage point, and inflation rises by almost 2 percentage points.

The weakening of oil market conditions—including a larger decline in oil prices, a lower increase in oil export volume growth, and lower workers’ remittances than in the high-growth case— exerts a negative influence on the current account position, GNP growth, and rate of inflation in the group of Asian countries, particularly in 1986, when the change in oil prices is largest. The effects of the weakening in oil market conditions are mitigated by averaging over the six Asian countries, which include oil importers, oil exporters, and oil producers that do not export but satisfy some share of their domestic consumption. On balance, however, the six Asian countries in the aggregate are oil exporters. Thus the deterioration in oil market conditions dampens export volume growth and worsens the terms of trade. GNP growth weakens—only slightly in 1985, but by half a percentage point in 1986; with the fall in the terms of trade, real income growth and absorption growth also drop. In contrast, import volume growth is virtually unchanged because the effect of reduced absorption is offset by that of lower import prices for the oil importers in the group. These influences, together with the reduction of workers’ remittances from outside oil producing countries, weaken the current account by about $0.5 billion in 1985 and by about $1,5 billion in 1986. The debt service ratio rises by 0.3 percentage point in 1985 and by almost 1.0 percentage point in 1986. Because the fall in oil prices exerts the same effect on the absorption deflator in all the Asian countries, whether a country is a net oil exporter or an oil importer, it has a large impact on domestic inflation.

The final major influence on the current account position and GNP growth of the Asian countries is the stance of their demand management and exchange rate policies. The specification of absorption as a function of real income lends itself easily to a consideration of the effects of changes in policies. Specifically, by increasing the value of the parameter linking absorption growth and real income growth (g) above the value of 0.6 used in the simulations thus far, the results of less restrictive demand management policies can be investigated. Exchange rate developments also constitute a part of the policy response to slower growth in industrial countries. Specifically, in the simulation experiments above it is assumed that, by devaluing their currencies against the dollar, the authorities have sought to encourage exports and discourage imports.

A simulation was therefore run in which all control variables reflected the assumptions in the low-growth scenario, but g was set at 0.8—a value similar to that observed in 1984—and the value of the export-weighted average of the Asian currencies in terms of the dollar was dropped by 4.5 percent. Table 7 shows the difference between the outcome from this simulation and that based on the assumptions in the low-growth scenario with tight financial policies (g = 0.6) and the actual 8.6 percent depreciation of the Asian currencies. In general, the results show that, to the extent that the Asian countries implemented policies to contain absorption growth and provided strong price incentives to encourage exports and discourage imports, these countries were able to contain the worsening of the current account with little effect on GNP growth but with a substantial lowering of absorption growth.

The comparison of the simulations under the low-growth conditions and under different assumptions about the stance of demand management policies shows that an easing of policies would have reduced export volume growth by over half a percentage point in 1985 and by over a percentage point in 1986 relative to the outcome under tighter demand management policies. Most of this difference is accounted for by the smaller real depreciation of the Asian currencies. The real depreciation, however, is not as large as the nominal depreciation because some of the exchange rate change is passed on to domestic prices. Import volume growth, which is more responsive than export volume growth to current exchange rate changes, is substantially higher in the easier policy setting.

Table 7.Difference Between Simulation Results Under Changed Financial Policies in the Asian Countries
Economic Indicator19851986
CA / GNP-0.6-1.5
CAa-3.0-7.3
Export volume growth-0.7-1.3
Import volume growth2.53.1
Terms of tradeb0.30.8
Debt service ratioc0.20.9
Debt/exports4.012.4
GNP growth
Absorption growth0.60.9
Real income growth0.10.2
Inflationd-2.1-1.9
Note: The results are reported as the difference between the outcome under the assumption of easier financial policies in the Asian countries (g = 0.8 and a 4.6 percent depreciation of the export-weighted average of the Asian currencies against the dollar in both 1985 and 1986) and the outcome under the assumption of restrictive financial policies in the Asian countries (g = 0.6 and an 8.6 percent depreciation of the export-weighted average of the Asian currencies against the dollar in both 1985 and 1986). In both cases the control variables conform to values in the low-growth scenario; percentage-point differences are shown except where otherwise indicated.

In billions of dollars.

Index-point differential (1984 = 100).

Ratio of total debt service payments to receipts from exports of goods and services.

Absorption deflator.

Note: The results are reported as the difference between the outcome under the assumption of easier financial policies in the Asian countries (g = 0.8 and a 4.6 percent depreciation of the export-weighted average of the Asian currencies against the dollar in both 1985 and 1986) and the outcome under the assumption of restrictive financial policies in the Asian countries (g = 0.6 and an 8.6 percent depreciation of the export-weighted average of the Asian currencies against the dollar in both 1985 and 1986). In both cases the control variables conform to values in the low-growth scenario; percentage-point differences are shown except where otherwise indicated.

In billions of dollars.

Index-point differential (1984 = 100).

Ratio of total debt service payments to receipts from exports of goods and services.

Absorption deflator.

Thus, despite some improvement in the terms of trade (related to the small degree of monopolistic power Asian countries have over manufactured export prices), the current account position worsens by $3 billion (as a percentage of GNP, by more than half a percentage point) in 1985 and by over $7 billion (as a percentage of GNP, by more than 1½ percentage points) in 1986. Correspondingly, the debt service ratio rises by less than half a percentage point in 1985 but by almost a full percentage point in 1986. In contrast, GNP growth is unaffected by the alteration in policies; the combined effects of lower export volume growth and higher import growth are offset by higher absorption growth. Notably, therefore, the gain from the easing of policies arises not from higher output growth but from greater expenditure out of a given level of income; the cost is considerably higher debt that will eventually require adjustment.

III. Conclusions

The importance of industrial country growth for the current account positions and debt profiles of developing countries is emphasized in recent studies examining the economic linkage between industrial and developing countries. The present paper has presented a highly aggregated framework for examining these links for six Asian countries considered as a group. One important feature of the paper has been to broaden the focus of this type of investigation to include the effects of industrial country growth not only on the external positions and debt profiles of developing countries, but also on output, absorption, and inflation in the developing countries themselves. An additional feature of the paper has been to examine the role of financial policies in developing countries in the adjustment to slower growth in industrial countries.

The results of this exercise need little elaboration. In 1985 and 1986 the slowdown in growth in industrial countries had a large effect on the current account position, debt profile, and GNP growth rate of the developing countries studied. Changes in other important variables in industrial countries—in particular, the decline in interest rates—went only a small way toward offsetting these adverse developments. Moreover, the weakening of the current account position and the increase in the debt-servicing burden was contained through a tightening of financial policies in developing countries that involved a considerable sacrifice of absorption but relatively little cost in terms of growth forgone. The result that the tightening of policies, including a substantial depreciation of the Asian currencies, had only a small effect on growth reflects the high elasticity of trade volumes with respect to relative prices. As such, this result is highly sensitive to changes in parameter assumptions and probably cannot be generalized for individual countries in the group or for other countries.

One issue that has engendered considerable debate is whether the deleterious effects on developing countries of a slowdown of economic growth in industrial countries would be offset by an accompanying decline in dollar interest rates. An important difficulty in resolving this debate lies in establishing a uniform criterion for judging the costs for developing countries of lower growth in industrial countries relative to the benefits to developing countries from lower interest rates. Dornbusch (1985), for example, investigated the effects of economic developments in industrial countries on welfare in developing countries by calculating an intertemporal utility function. In this approach, a reduction in the real interest rate on external debt significantly improves welfare, whereas in the absence of specific distortions slower growth of industrial countries only affects welfare to the extent that it worsens the terms of trade. Cline (1984) examined the effects of economic developments in industrial countries mainly from the perspective of the growth of debt in several major debtor developing countries and of the countries’ ability to service that debt. In his model he found that to offset the effect of a percentage-point reduction in growth in the economies of the Organization for Economic Cooperation and Development on the average current account position of 19 major debtor countries over a four-year period would require a decline of 7 percentage points in the interest rate the debtor countries pay on external debt.

Results from the simulations presented in this paper, although not fully consistent with those from either of these other models, suggest conclusions similar to those reached by Cline. Rough calculations suggest that growth in industrial countries that is lower by 1 percentage point per year would have to be matched by a 5-percentage-point reduction in interest rates if the current account position of the six Asian countries were to remain unchanged after a two-year period. Moreover, this calculation assumes restrictive financial policies in the Asian countries; if financial policies were easier, the required reduction in interest rates would be greater.

The relative magnitudes of the effects of lower interest rates and of slower growth based on the simulation results in this paper vary from those of Cline for at least two reasons. First, the simulations in the present exercise indicate a somewhat smaller effect of a slowdown in industrial country growth on the current account imbalances in developing countries and, therefore, on the level of indebtedness of developing countries. Second, the composition of the countries examined, and therefore the structure of debt, considered in the present paper differs from that in Cline’s work. In any event, it should be emphasized that calculations such as these are highly approximate and vary considerably with changes in other control variables.

Although the present paper does not explicitly address the linkage between specific policies in industrial countries and economic performance in developing countries, the simulation results do have important implications for such linkage. In particular, the manner in which the current large externa! imbalances among industrial countries are dealt with will significantly affect the determination of current account positions and growth rates in developing countries. A substantial further depreciation of the dollar against the Asian currencies would weaken the external position of the countries investigated in this paper. On the one hand, if such a depreciation were the result of a contraction in fiscal deficits and an easing of monetary policy in industrial countries so as to permit a further decline in dollar interest rates, the adverse effects of the depreciation on developing countries’ current account and debt positions could be more than offset. On the other hand, if the depreciation of the dollar took place with no policy adjustments in industrial countries—thus raising the possibility of higher interest rates, lower growth, and increased protectionism—the results for developing countries would be substantially worse than even those of the low-growth scenario examined in this paper.

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*Ms. Schadler, an Assistant Division Chief in the Asian Department, holds degrees from Mount Holyoke College and the London School of Economics and Political Science. The author thanks her colleagues in the Fund for useful discussions while preparing this paper and Toshiki Yotsuzuka for his help with an earlier version.
1The countries included in the group are India, Indonesia, the Republic of Korea, Malaysia, the Philippines, and Thailand. Together these countries account for just over 50 percent of total gross national product (GNP) of the developing countries in Asia and for 90 percent if China is excluded. Despite its importance in the region, China was excluded because it was believed that its economic structure was not well represented by the type of behavioral relationship specified in the model.
2The assumption that lower U.S. interest rates would accompany lower industrial country growth reflects the view that a reduction in credit demand associated with lower growth would reduce interest rates. It might also be argued that lower U.S. interest rates would stimulate demand and therefore be consistent with higher industrial country growth.
3The assumptions about dollar export unit values in industrial countries and about the exchange rate of major currencies against the dollar are closely interrelated. An appreciation of other major currencies against the dollar raises dollar-denominated export unit values of industrial countries other than the United States that tend to fix export prices in their own currencies. Thus, despite the expectation that lower growth in industrial countries would be associated with lower price increases, the opposite is assumed because of the sharp depreciation of the dollar that is seen, at least partially, as the result of lower growth in the United States.
4In contrast, Sachs and McKibbin (1984) assumed that developing countries are constrained by a given amount of external lending that industrial countries decide to undertake. This is a reasonable approach when considering developing countries as a group, as opposed to the subset of developing countries included in the present exercise.
5The effect on the terms of trade of a fall in prices would still exert a substantial negative influence on income growth and the current account.
6Nontraded goods constitute a broad category encompassing both manufactured goods and primary commodities. Although there is some overlap between traded and nontraded goods, they are considered to be separable in order to keep the model tractable.
7The weights are based on export shares in 1984, although the outcome is almost identical to that obtained from using import shares.
8The relevant exchange rate variable from the viewpoint of demand management objectives is actually the real effective exchange rate. Ex ante, however, the nominal exchange rate is the relevant policy instrument because the real exchange rate cannot be fixed.
9The definition of industrial countries and the weighting scheme used for the aggregate correspond to those in the WEO.
10Again, the assumptions used are estimates.
11It is assumed that countries other than the United States have a weight of about 0.5 in the calculation of the average level of trade prices.
12On an end-of-period basis, the appreciation of other currencies against the dollar was larger in 1985 than in 1986. Because most of the appreciation occurred late in 1985, however, the average appreciation for the year as a whole—the variable of relevance for price behavior—is stronger in 1986.
13These are not necessarily the actual levels or growth rates obtained from the simulations. Rather, they are the values that result if the difference between the simulation results in the high- and low-growth cases is superimposed on the actual outcome for 1985 and the WEO forecasts for 1986. Because the simulations do not account for a variety of factors that bear on the actual outcome (such as specific policy intentions and supply-side disturbances), the simulation results are not meant to be forecasts and are reported only as changes from the base case, which uses hypothetical values for the exogenous variables.

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