World Economic Outlook—May 1997
A Survey by the Staff of the International Monetary Fund

I. Global Economic Prospects and Policies

Advanced Economies

Recent indicators point to a moderate firming of output growth in the advanced economies in 1997-98 following a slowdown in a number of countries, particularly in Europe, in 1996 (Table 1). Long-term interest rates have come down significantly in many countries with inflation remaining generally subdued, and the danger of overheating has subsided in the newly industrialized economies of Asia following policy tightenings (Box 1). External imbalances are projected to remain relatively well contained, although a few large surplus and deficit positions may not be sustainable. And exchange rates of the major currencies appear to be reasonably consistent with fundamentals, taking into account cyclical conditions.

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Table 1. Overview of the World Economic Outlook Projections
(Annual percent change unless otherwise noted)
Differences from
October 1996
  1995 1996 1997 1998 1996 1997

World output 3.7 4.0 4.4 4.4 0.0 0.2
Advanced economies 2.5 2.5 2.9 2.9 -0.0 0.1
   Major industrial countries 2.0 2.2 2.6 2.6 0.0 0.1
      United States 2.0 2.4 3.0 2.2 0.0 0.6
      Japan 1.4 3.6 2.2 2.9 0.0 -0.5
      Germany 1.9 1.4 2.3 3.0 0.1 -0.1
      France 2.2 1.3 2.4 3.0 0.1 -0.0
      Italy 3.0 0.7 1.0 2.4 -0.4 -1.2
      United Kingdom 2.5 2.1 3.3 2.8 -0.1 0.4
      Canada 2.3 1.5 3.5 3.4 0.1 0.3
   Other advanced economies 4.2 3.7 3.8 4.1 -0.0 -0.1
   Industrial countries 2.1 2.3 2.7 2.7 0.0 0.2
   European Union 2.5 1.6 2.4 2.9 0.0 -0.1
   Newly industrialized Asian economies 7.4 6.3 5.7 6.1 -0.3 -0.9
Developing countries 6.0 6.5 6.6 6.5 0.2 0.5
   Africa 2.9 5.0 4.7 4.8 0.0 -0.4
   Asia 8.9 8.2 8.3 7.7 0.2 0.7
   Middle East and Europe 3.8 4.5 3.9 3.9 0.7 0.6
   Western Hemisphere 1.3 3.5 4.4 5.1 0.5 0.5
Countries in transition -0.8 0.1 3.0 4.8 -0.7 -1.0
   Central and eastern Europe 1.6 1.6 3.0 4.7 -0.5 -1.2
      Excluding Belarus and Ukraine 5.0 3.4 3.3 4.7 -0.8 -1.4
   Russia, Transcaucasus, and central Asia -4.0 -1.9 3.0 4.9 -0.9 -0.8
World trade volume (goods and services) 9.2 5.6 7.3 6.8 -1.1 0.2
   Advanced economies 8.7 5.3 5.9 6.1 -0.5 -0.1
   Developing countries 11.6 8.3 10.7 8.4 -2.9 0.6
   Countries in transition 15.9 7.7 9.8 6.8 -4.2 1.8
   Advanced economies
8.4 5.0 6.9 6.7 -0.2 0.2
   Developing countries 11.2 7.0 11.0 8.0 -3.3 0.5
   Countries in transition 13.5 4.7 6.9 7.0 -5.8 1.1
Commodity prices
   (In SDRs) 1.9 24.3 1.4 -6.4 6.4 9.0
   (In U.S. dollars) 8.0 18.9 -3.6 -6.7 5.8 4.0
   (In SDRs) 2.1 3.1 5.2 0.1 -1.7 7.7
   (In U.S. dollars) 8.2 -1.3 0.0 -0.3 -1.9 2.5
Consumer prices
Advanced economies 2.6 2.4 2.5 2.5 -0.0 -0.1
Developing countries 21.3 13.1 9.7 8.5 -0.2 -1.1
Countries in transition 119.2 40.4 30.7 11.6 1.4 14.1
Six-month LIBOR (in percent)3
On U.S. dollar deposits 6.1 5.6 6.0 6.1 -0.0 -0.0
On Japanese yen deposits 1.3 0.7 1.0 2.8 -0.3 -1.4
On deutsche mark deposits 4.6 3.3 3.3 3.8 0.0 -0.5

   Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during March 1-18, 1997, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.
   1Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil. The average price of oil in U.S. dollars a barrel was $20.42 in 1996; the assumed price is $19.69 in 1997 and $18.36 in 1998.
   2Average, based on world commodity export weights.
   3London interbank offered rate.

Box 1. Revised Country Classification

Beginning with the current issue of the World Economic Outlook, a number of newly industrialized economies in Asia (Hong Kong, Korea, Singapore, and Taiwan Province of China), as well as Israel, are considered together with the group of countries traditionally known as industrial countries. The reclassification reflects the advanced stage of economic development these economies have now reached. In fact, they all now share a number of important industrial country characteristics, including per capita income levels well within the range indicated by the group of industrial countries, well-developed financial markets and high degrees of financial intermediation, and diversified economic structures with relatively large and rapidly growing service sectors. Rather than retaining the old industrial country label, the expanded group is labeled the "advanced economies" in recognition of the declining share of employment in manufacturing common to all of these economies.

Despite the many positive developments, long standing differences in the advanced economies' ability to achieve and maintain high levels of employment have become even starker in recent years. In much of continental Europe, rates of unemployment have recently risen to postwar record levels, and widespread resort to work sharing and early retirement is not only adding to the underutilization of labor resources but in many cases is raising business costs and budgetary expenditures. The growing imbalance between the inactive population and those employed may require further increases in already very heavy tax burdens. It also undermines future economic growth and living standards and threatens the viability of public pension systems. This situation is particularly striking compared with the impressive ability of the United States to create jobs for a rapidly expanding labor force and the progress achieved by the United Kingdom and a number of smaller countries in reversing earlier increases in trend unemployment. Addressing the malfunctioning of labor markets has clearly become the most pressing economic policy issue of the late 1990s for many advanced economies.

Both macroeconomic and structural policies need to be strengthened to improve growth and labor market performance. For fiscal policy, as discussed below, the priority remains the need to further reduce budgetary imbalances, which are still excessive in many cases. This is a key requirement for restoring higher sustainable rates of economic growth in the medium term. As discussed in the May 1996 World Economic Outlook, the short-term effects on output and employment of fiscal consolidation depend partly on the composition of fiscal adjustment measures. Also, in countries with unsustainable fiscal imbalances credible steps to improve the fiscal outlook can have positive effects on confidence and activity relatively quickly. Normally, some short-run costs tend to be associated with implementing budgetary retrenchments, but progress toward fiscal consolidation and the achievement of reasonable price stability provide added scope for monetary policy to support activity in countries with significant margins of slack. This has been generally recognized by monetary authorities, which have appropriately eased official interest rates to support demand when price stability would not seem to be threatened. Even so, official interest rates could have been adjusted more rapidly in some European countries in recent years in response to widespread signs of cyclical weakness, without compromising the credibility of monetary policy. This would have helped to put the recovery on a stronger footing.

The greatest need for policy action to strengthen Europe's economic performance is in the structural area (which is also true of Japan, as discussed below). There has been some progress in reforming the complex web of regulations, benefits, and taxes that discourage job creation and job search, but efforts to date have been piecemeal and inadequate in many cases. Opposition to more comprehensive reforms stems from fears that changes in Europe's social welfare system would reduce job security, widen wage differentials, and threaten living standards. Mounting evidence that labor market regulations and high benefit levels are major contributing factors to high and persistent unemployment, excessive tax burdens, chronic fiscal imbalances, and lack of economic dynamism is too often ignored.

It is therefore essential to strengthen the public's understanding of the economic forces that are at work. At the same time, there is a continued need to persevere with comprehensive reforms to reduce overly generous levels of unemployment compensation, tighten eligibility criteria, reduce taxes on employment, and facilitate not only job search and raining but also restructurings and layoffs—and thereby hirings. Such reforms would allow market forces a greater role in helping to clear the labor market at much lower levels of unemployment. Tax and transfer systems also will need to be reformed so that they may better meet equity objectives and safeguard a reasonable level of social protection without the negative implications for incentives and employment that are clearly associated with present arrangements. Reducing unemployment would in itself alleviate a major source of income inequality and social exclusion.

To what extent can the difficulties in labor markets in the advanced economies—whether in the form of unemployment or widening wage differentials—be attributed to pressures from globalization? As discussed in this World Economic Outlook, there is little indication that increased trade with low-cost countries has contributed significantly to the declining share of employment in manufacturing, which is the principal tradable goods sector. Nor does it seem to explain much of the relative decline of low-skilled wages. The claim that these phenomena stem from globalization and could be alleviated through trade protection and other inward-looking policies does not appear to be supported by the evidence. The relative decline of employment in manufacturing has occurred in spite of relative stability in the distribution of expenditures between manufactures and services at constant prices; it seems attributable mainly to the relatively rapid growth of labor productivity in manufacturing, as a result of technical progress and the normal process of capital deepening. Although the share of manufacturing employment has been declining in these countries—a development referred to as deindustrialization—the trend of industrial output remains positive in most of them.

As economies mature, it seems likely that the share of employment in industry will continue to fall while the importance of services increases further. However, whereas many service industries attract highly qualified labor into well-paid jobs, some service jobs are in activities with low value added and paying correspondingly low relative wages. This is one of the ways in which technological change appears also to have affected wage differentials. The precise mix of service jobs created, however, is likely to depend on the quality of the labor available. Better education and training, therefore, should be of high priority in dealing with both the unemployment problem and the tendency for wage differentials to widen as technical progress demands new skills. In many countries, governments are appropriately pursuing policies whereby those who benefit the most from these developments contribute to the assistance of those less well positioned. However, in designing such policies it is important to avoid creating poverty traps while promoting incentives to enhance skills and to seek out better employment opportunities.

The need for fiscal consolidation is another key policy priority in many advanced economies. There has been welcome progress in many cases and structural fiscal imbalances have been brought down, on average, from 3 1/2 percent of GDP in 1990 to about 2 percent of GDP in 1996. Nevertheless, fiscal imbalances are still excessive in a large number of countries, with the prospective aging of populations and the attendant pressures on health and pension outlays adding to the urgency of fiscal reforms. The need to restore and safeguard sound public finances has led a number of countries to consider introducing codes of fiscal transparency as exemplified by New Zealand's Fiscal Responsibility Act and the Charter of Budget Honesty that is expected to be enacted in Australia. Similar concerns have stimulated interest in rules for the conduct of fiscal policy, as reflected in the Stability and Growth Pact that has now been agreed among members of the European Union, and the discussions of balanced budget constitutional amendments in the United States and Switzerland.

The introduction of fiscal rules is one approach to achieving greater fiscal discipline and to avoiding the "deficit bias" that has emerged from discretionary policy or from the unintended consequences of social insurance programs adopted under more favorable economic circumstances. Sustained and committed efforts to contain fiscal imbalances through discretionary actions could equally achieve the same objective. Opponents of fiscal rules argue that they could unduly constrain the conduct of fiscal policy during cyclical downturns. But this does not need to be the case. In fact, the increased discipline involved in the adherence to such rules may well permit a greater stabilizing role for fiscal policy than has been possible in most countries for a long time. It is of course essential that fiscal rules be well designed and provide reasonable room to accommodate cyclical fluctuations. A requirement to balance revenues and expenditures every year would necessitate immediate adjustments of the level of outlays or taxes in response to cyclical variations in revenue and expenditure, which would be neither feasible nor desirable. Moreover, to be effective, any fiscal rule would need to be supported by increased transparency of off-budget transactions, unfunded pension liabilities, and other future commitments.

The year 1997 is especially important for Europe—the test year for deciding, by the spring of 1998, which members of the EU meet the criteria for initial participation in the planned Economic and Monetary Union (EMU). This project has already achieved much, notably in terms of promoting a sustained decline in inflation and an impressive start on fiscal consolidation. Public sector deficits, which averaged 6.5 percent of GDP in 1993, had been reduced to 4.4 percent of GDP by last year, when 6 of the 15 members were in compliance with the 3 percent reference value for budget deficits that forms part of the eligibility criteria for participation in EMU. Indeed, had it not been for the relatively large output gaps, it is estimated that all but four of the members would have met that reference value last year (Chart 3). Despite continuing output gaps, virtually all members are aiming to satisfy the deficit criterion in 1997, and a fortiori in 1998 and beyond. The policy achievements that have been accomplished set the stage for stronger economic performance in the future. But the run-up to EMU is nonetheless exacting a toll, both because of the short-term consequences of fiscal consolidation and also by contributing to uncertainties and hesitancies in business and consumer confidence that have fed back into demand and activity. It is critical to get through this period promptly by bringing the project to term within the agreed time frame. To this end, governments need to continue to follow through on their policy commitments and objectives, in both the fiscal and structural areas. A strong foundation is being laid, and it is time to begin to reap the fruits.

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EU: General Government Budget Positions

The EMU project reflects the political will to forge ever-closer links among the member countries of the EU. From an economic perspective, the attractiveness of monetary union includes the prospect of greater economic and financial stability among the participants, associated with a strong commitment to price stability, to be implemented by one independent central bank, and increased efforts to achieve and safeguard fiscal balance. This should help contain real interest rates, especially in countries where risk premiums have been high. In addition, the monetary union is likely to foster deeper capital market integration in Europe and help increase efficiency in financial markets. The introduction of a single currency will also eliminate the potential for tensions to develop among the members' currencies, which in the past have often accentuated the effects of asymmetric economic and financial disturbances.

Of course, disturbances may still affect countries unevenly, and a need to promote a smooth adjustment to such shocks will remain. Since monetary policy will be determined by areawide considerations, fiscal policy will have to play some role, subject to the constraints agreed in the framework of the Stability and Growth Pact. In some instances, financial assistance from the EU budget may be warranted, as indicated in the Maastricht Treaty, to help a country address severe difficulties caused by exceptional occurrences beyond its control. Most critical for the success of the EMU project, and for the dynamism of the European economies, is the need to improve the functioning of European labor markets. From this perspective, most members of the EU must strive to make much more progress irrespective of their plans to participate.

Changes in the exchange rates among the major currencies during the past 18 months have been generally consistent with underlying fundamentals and relative cyclical positions and constitute a substantial correction of the misalignments of spring 1995. These exchange rate changes are a reflection of, and are helping to reinforce, the policy stances that are needed from a cyclical perspective—in the United States and the United Kingdom to restrain inflationary pressures, and in Japan, Germany, and France to support fragile recoveries. However, they should not be viewed as fully substituting for adjustments of monetary policies that may be needed for domestic reasons. Over the medium term, some of the recent appreciation of the dollar and depreciation of the yen may not be compatible with further reduction of external imbalances, and these currency movements may be reversed as cyclical positions become less uneven.

*  *  *

With regard to prospects and policies in individual countries, the United States has been remarkably successful in maintaining a high level of employment while reducing its fiscal deficit and safeguarding low inflation. The economy expanded by 2 1/2 percent in 1996, and price pressures remained subdued despite high resource utilization, including a tight labor market. In 1997, real GDP is expected to increase by 3 percent, somewhat faster than envisaged in the October 1996 World Economic Outlook. To reduce the risk of rising inflation the Federal Reserve raised short-term rates slightly in late March. Given the strong underlying growth momentum, a moderate further firming of monetary conditions may soon be needed and is assumed in the forecast (the policy assumptions underlying the projections are set out in Box 2). Continued efforts are also needed to balance the budget over the medium term and to avert a rise in the deficit in the longer run due to the rapid growth in spending on pensions and medical care for the elderly. Enhancing national saving performance through a stronger fiscal position would help sustain future growth. It would also be the best way, from both a domestic and global perspective, to address the chronic external deficit.

Box 2. Policy Assumptions Underlying the Projections

Fiscal policy assumptions for the short term are based on official budgets adjusted for any deviations in outturns as estimated by IMF staff and also for differences in economic assumptions between IMF staff and national authorities. The assumptions for the medium term take into account announced future policy measures that are judged likely to be implemented. Both short-term and medium-term projections are based on information available up to end-March 1997. In cases where future budget intentions have not been announced with sufficient specificity to permit a judgment about the feasibility of their implementation, an unchanged structural primary balance is assumed, unless otherwise indicated. For selected advanced economies, the specific assumptions adopted are as follows (see Tables 4-5, and A15-A16 in the Statistical Appendix for the projected implications of these assumptions):

United States: For the period through FY 1999, fiscal revenues and outlays at the federal level are based on the administration's February 1997 budget proposal, after adjusting for differences between the IMF staff's macroeconomic assumptions and those of the administration. For FY 2000 onward, the federal government's structural primary balance as a proportion of GDP is assumed to remain unchanged from its projected FY 1999 level.

Japan: The projections take account of policies announced in the 1997 budget, in particular an increase in the consumption tax rate from 3 percent to 5 percent and an end to the temporary income tax cut. Reflecting likely moves toward fiscal consolidation, public investment is assumed to total ¥570 trillion between FY1995 and 2004, rather than the ¥630 trillion assumed in the medium-term public investment plan and earlier WEO projections. The projections assume that the 1994 pension reform plan is fully implemented.

Germany: The 1997 revenue and expenditure projections take into account the effects of the government's consolidation package (comprising measures at the federal, state and local levels, and the social security funds) and the 1997 Tax Act as passed by parliament in December. The difference with the official deficit projection of 2.9 percent is mainly due to a slightly less sanguine view of the macroeconomic environment, of the financial position of social security funds, and of tax revenues; it also reflects available information on fiscal developments so far in 1997. In 1998, and over the medium term, the staff projections assume an unchanged structural primary balance.

France: Budget projections for 1997 reflect the government's plans for the state budget (a freeze of nominal expenditure, some income tax relief, and a special transfer from France Télécom) and assume that the social security expenditure ceilings will be respected. The blocking of F 10 billion in state expenditure announced in early March is also included, as is the expected deterioration in the finances of the unemployment insurance fund. For 1998, it is assumed that the ratio of revenue to GDP drops by 0.3 percentage points (the revenue ratio in 1997 having been boosted by the special transfer mentioned above) and that most categories of primary expenditure grow in line with potential output. For the medium term, the projections assume an unchanged structural primary balance.

Italy: The projections take into account measures that have already been implemented as part of the 1997 budget and the supplementary "effort for Europe," as well as the additional package announced in March 1997. In the absence of an updated plan for 1998-99 following the strengthening of the 1997 effort, the projections for those years are made on a current services (tendenziale) basis, and reflect also the phased resumption of tax refund payments postponed from 1997. Projections beyond 1999 are based on an unchanged structural balance.

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

Canada: Federal government outlays for departmental spending and business subsidies are assumed to conform to the medium-term commitments announced in the February 1997 budget. Other outlays and revenues are assumed to evolve in line with the IMF staff's projected macroeconomic developments. The projections include a contingency reserve for 1997/98 through 1998/99 and assume a reduction of 10 cents in the employment insurance premium in 1998/99 and a reduction of 5 cents a year thereafter. The fiscal situation of the provinces is assumed to be consistent with their stated medium-term targets.

Australia: Projections are based on the Commonwealth government's 1996-97 midyear economic and fiscal outlook, adjusted for any differences between the economic projections of the IMF staff and the authorities. Unchanged policies are assumed for the state and local government sector from 1997.

Belgium: The 1997 projections are based on the 1997 budget and the IMF staff's macroeconomic projections; an allowance is made for some slippage in social security expenditure, but this is offset by lower-than-budgeted interest payments. For 1998, the decline in the deficit reflects mainly lower interest payments and a partial closing of the output gap. Beyond 1998, the structural primary balance is assumed unchanged.

Israel: The fiscal assumptions are in line with the government's medium-term fiscal plan, which establishes annual targets for the budget deficits until 2001.

Korea: Projections for 1997-2002 assume that the central government budget remains broadly in balance and that small surpluses continue to be recorded at the general government level.

Netherlands: The 1997 projections are based on the 1997 budget and IMF staff estimates for interest rates and economic activity; they assume that a portion of the higher-than-anticipated revenues recorded in 1996 was structural in nature. The 1998 projections reflect the government's expenditure norm, with no further tax cuts. Beyond 1998, the structural primary balance is assumed constant.

Spain: Fiscal projections for 1997 assume that the budget is implemented as passed by parliament but allow for differences in macroeconomic assumptions and some expenditure overruns that are partially offset by lower interest payments. For 1998 and beyond, it is assumed that there is no major change in tax policy, the wage freeze ends, public sector wages grow at roughly the rate of increase of wages in the private sector, and goods and services purchases remain constant as a share of GDP.

Sweden: The medium-term projections are based on the government's multiyear consolidation program approved by parliament in 1995 and augmented by additional measures incorporated into the 1997 budget.

Switzerland: Projections for 1997-2000 are based on official estimates for current services. Thereafter, the general government structural primary balance is assumed to remain constant.

*  *  *

Monetary policy assumptions are based on the established framework for monetary policy in each country, which in most cases implies a nonaccommodative stance over the business cycle. It is generally assumed that official interest rates will firm when economic indicators suggest that inflation will rise above its acceptable rate or range and ease when indicators suggest that prospective inflation will not exceed the acceptable rate or range, that prospective output growth is below its potential rate, and the margin of slack in the economy is significant. For the exchange rate mechanism (ERM) countries, which use monetary policy to adhere to exchange rate anchors, official interest rates are assumed to move in line with those in Germany, except that progress on fiscal consolidation may influence interest differentials relative to Germany. On this basis, it is assumed that the London interbank offered rate (LIBOR) on six-month U.S. dollar deposits will average 6 percent in 1997 and 6.1 percent in 1998; on six-month Japanese yen deposits will average 1.0 percent in 1997 and 2.8 percent in 1998; and on six-month deutsche mark deposits will average 3.3 percent in 1997 and 3.8 percent in 1998. Changes in interest rate assumptions compared with the October 1996 World Economic Outlook are summarized in Table 1.


In Canada, after a disappointing performance in 1995 and early 1996, economic activity picked up in the second half of last year; unemployment has begun to decline, and the economy is poised for solid growth in 1997 and 1998. The general government fiscal deficit, which reached 7 1/2 percent of GDP in 1992, has been reduced progressively and is expected to disappear next year. This has helped restore financial market confidence, which together with subdued inflation has allowed official interest rates to be reduced well below U.S. money market rates without undermining the credibility of the authorities' commitment to price stability or weakening the exchange rate.

The recovery in Japan became more broadly based in 1996 and the economic climate improved under the influence of supportive fiscal and monetary policies and a correction of the excessive appreciation of the yen through the spring of 1995. GDP growth picked up in the fourth quarter reflecting strong domestic demand as well as the effects of yen depreciation on net exports. Easy monetary conditions and improving labor market conditions are expected to underpin continued recovery at a moderate underlying pace in 1997. Although there is potential for growth to turn out stronger than expected, uncertainties remain about the impact of fiscal consolidation measures and the effects of strains in the financial system. Thus monetary policy will need to remain easy until an autonomous recovery is firmly established. Fiscal consolidation should proceed at a sustained pace without undermining prospects for continued recovery.

The sluggish performance of the Japanese economy in recent years reflects not only weak demand related partly to financial sector difficulties but also the lack of progress in many areas of structural reform. This is apparent in the divergences that have built up over time between the performances of the tradable and nontradable goods sectors. The latter have remained overregulated, subject to a low degree of competition, relatively inefficient, and characterized by very high cost and price levels. As in other mature economies, however, the tradable goods sector accounts for a declining share of total employment so that jobs and living standards increasingly have to be supported by more dynamic service sectors. It will therefore be important to translate quickly into substantive reforms the growing consensus on the need for further deregulation.

In both Germany and France, growth slowed to about 1 1/2 percent in 1996 and is expected to be in the range of 2-2 1/2 percent in 1997. In Germany, strong exports should eventually spill over into domestic demand, which will also benefit from lower interest rates. M3, the principal monetary aggregate monitored by the Bundesbank, has expanded relatively strongly. However, confidence indicators are still quite mixed, unemployment has risen to postwar records, and the pace of fiscal consolidation is set to strengthen in 1997. In the structural area, Germany is confronted both with the need to enhance the flexibility of its labor and product markets and with the special challenges posed by the dependence of the eastern Länder on transfers and subsidies. In France, the business climate has improved somewhat, but consumer confidence is still weak, and the projected pickup in business investment seems fragile. Moreover, it remains necessary to implement more comprehensive labor market, tax, and public sector reforms in order to foster job creation and entrepreneurship.

Short-term interest rates have been reduced considerably in both Germany and France to help offset recessionary forces. In combination with the absence of inflationary pressures, and the recent helpful depreciation of the deutsche mark and the franc against the U.S. dollar and some other European currencies, the easing of monetary conditions has helped to contain long-term interest rates in the face of higher bond yields in the United States. All these developments provide good reasons to expect the recovery to gain some momentum. While there is upside potential, however, there remain downside risks, and it is too early to conclude that the process of monetary easing has fully run its course.

In Italy, after relatively strong growth in 1995, recovery stalled in 1996 and activity is now expected to remain subdued in 1997, mainly owing to an accelerated pace of fiscal consolidation and the lagged effects of the lira's appreciation. Considerable progress has been made in reducing inflation to the levels of Italy's EU partners and in strengthening the credibility of the authorities' commitment to reduce the budget deficit. This contributed in 1996 to a marked narrowing of the premium in long-term interest rates over those of Germany and to the correction of the earlier excessive depreciation of the lira, which permitted its return to the European exchange rate mechanism (ERM) in November. Lower debt-servicing costs and the strengthening of fiscal plans, including the recent additional package, are expected to bring the fiscal deficit close to the Maastricht reference value in 1997. The authorities have announced the start of a thorough review of pension and welfare spending, which should help ensure that the progress recorded to date is sustained in 1998 and beyond.

The United Kingdom's solid upswing, now in its fifth year, is expected to continue in 1997 on the strength of consumption and a projected pickup in business investment. The recent appreciation of sterling is helping to dampen inflationary pressures and seems to pose no immediate threat to the expansion, but the forces supporting growth may be tilting too much toward domestic demand. Wage increases have picked up as unemployment has continued to fall, and there is a risk that inflation will again exceed the authorities' target (of 2 1/2 percent or below) in 1998 and beyond unless further action is taken to rein in demand. This would need to be achieved in the first instance through an early tightening of monetary policy. While the fiscal deficit has been reduced substantially in recent years, the November budget tightened the fiscal stance only slightly further in the near term, and more fiscal action is needed to help restrain demand and alleviate the burden on monetary policy.

Many of the smaller advanced economies have enjoyed robust growth in recent years and several have taken measures to reduce the risk of overheating, generally with considerable success. In fact, official interest rates in Australia have declined recently in response to moderating inflation. Korea and Singapore experienced a moderation of growth in 1996 as a result of a slowdown in exports and, in Korea, some policy tightening. With the transfer of sovereignty over Hong Kong to China proceeding smoothly, and apart from the short-term effects of labor unrest in Korea, the prospects for the newly industrialized economies in Asia remain bright, even though their future growth may be somewhat slower than the rapid pace of catching up sustained in the past. In Israel, which has also been grappling with overheating, the planned tightening of the fiscal stance is needed to relieve the burden on monetary policy, reduce the external deficit to a more sustainable level, and help bring inflation into the low single digits typical of other advanced economies. In Europe, Ireland and Norway are expected to continue to expand rapidly. In both cases, vigilance is needed to prevent overheating; investments abroad through Norway's "petroleum fund" should help reduce upward pressure on the krone associated with large oil revenues. In Denmark and the Netherlands also, action may be needed to contain relatively buoyant domestic demand; because of the continued easy monetary stance warranted in Germany, fiscal policy should provide the necessary degree of restraint in both of these ERM countries.

In other EU countries, where margins of slack are still significant, fiscal consolidation is helping to relieve the burden on monetary policy and is improving the economic outlook. In Spain, thanks also to an impressive drop in inflation, both short-term and long-term interest rates have come down sharply. In Sweden and Finland, solid recoveries from serious downturns early in the decade are set to continue, supported by subdued inflation, improving fiscal positions, and a marked narrowing of interest differentials vis-à-vis Germany. Activity has also picked up in Austria, Belgium, and Portugal. Outside the EU, there are still no clear signs of recovery in Switzerland from a protracted recession that left the economy stagnant in 1996 for the sixth successive year. However, an easier monetary stance and correction of the earlier excessive appreciation of the Swiss franc have improved the prospects for a turnaround.

©1997 International Monetary Fund

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