The world economy and exchange rates - World Economic Conditions

The World Economy and Exchange Rates

The inertia of 1990's global economic slowdown will keep 1991's real GDP growth at 1.0 percent - the weighted average of 1.3 percent for the developed economies, 2.6 percent for the developing countries (LDC's), and 4.4 percent for Central Europe and the USSR. World economic growth in 1990-91 is the trough in the business cycle that last peaked in 1988 and which is projected to slope upward starting in 1992. A recovery to 3.3 percent in real GDP growth in 1992 will reflect rebounds in the developed economies of 1.8 percent, 2.7 percent in the LDC's, and 3.9 percent in Central Europe and the USSR.

Inflation is projected to subside substantially in 1991, and by more in 1992. Weaker overall demand, and crude oil prices at or under $20 per barrel, will slow increases in consumer prices, which should eventually lead to real output gains in 1992 for most countries. Significant recoveries in economic activity are expected in North America, Latin America, and the Middle East in 1992. Central Europe and the USSR will remain in recession. Stronger growth in Asia will be driven by a 14-percent nominal gain in export earnings in 1992, a portion of which derives from Japan's increased import demand.

Agricultural commodity prices have trended downward since 1989. Both agricultural raw materials and food have lost 11.2 and 8.8 percent, respectively, of their values from 1989. Current prices for food are only 8 percent higher than in 1985, whereas raw materials prices are still 30 percent higher. Sagging world demand, large crop harvests, and tighter worldwide money have pushed inflation down and dragged agricultural commodity prices down as well. Agricultural export subsidies could potentially increase if GATT negotiations do not succeed, bringing further deterioration in agricultural trade and prices.

The Developed Economies

Japan and the European Community (EC) are experiencing a cyclical slowdown. In Japan, higher interest rates and rocky equity markets have substantially reduced domestic investment growth, projected to be less than half 1990's 10.6-percent real gain. Also, the yen's appreciation against the dollar in 1990 and the current U.S. recession will contribute to Japan's expected lower export growth in 1991. Similarly, in Europe, much higher German interest rates and exchange rate appreciation against the dollar (in 1990) caused the cyclical adjustment, part of which is the EC's new trade deficit with the United States. A reversal of these trends is expected in 1992 as France, Italy, and the United Kingdom post higher real GDP growth.

The United States, Canada, and the U.K. are expected to post impressive real GDP gains of 3.3, 3.9, and 2.5 percent in 1992, respectively, from their current mild recessions. Germany will continue to expand at a healthy 3.1 percent in 1992 despite slowing domestic demand. Japan should once again be growing at a strong 3.8-percent pace in 1992 as private consumption and exports stage a comeback, along with public expenditures growth.

The Developing Countries

Real output growth in the LDC's will double in 1992 if the projected expansions in Latin America (from 1.5 percent in 1991 to 3.6 percent in 1992), and in the Middle East (from -7.9 to 8.8 percent) materialize. A fourfold reduction in inflation in 1991 and a further halving in 1992 are counted on to pull Latin America out of its recession in 1991. In the Middle East, the presumed return to normal activity in Kuwait and the lifting of economic sanctions against Iraq should fuel much of the region's recovery in 1992, despite the projected languid performance in Saudi Arabia and other neighboring countries. Lower real revenues from Europe. The recent rise in the value of the dollar, however, will raise oil import costs of many LDC's. The weak developed economies will seriously reduce their import demand from Africa and Latin America in 1991, and these regions' heavy external debt will in turn adversely affect their own import demand. Overall, world real exports will grow faster (above 5 percent) starting in 1992 even as export price increases fall along with general consumer price inflation.

A Free Trade Agreement between the United States and Mexico, if successfully negotiated, may initially limit trade expansion as long as both countries remain heavily indebted and under pressure to increase exports to the rest of the world. In Central Europe, room for trade expansion is enhanced by the low volume of intra-regional trade, since previous trade ties were predominantly with the USSR. Export growth for the region is projected to turn positive in 1992 as more of the economies overcome recession and as economic activity in the West picks up.

World Petroleum

World oil prices are only marginally higher than spring 1990's average of $15 a barrel, just before the Persian Gulf crisis that doubled prices to $30 by the fourth quarter. Despite efforts by the Organizations of Petroleum Exporting Countries (OPEC) to cut its output by 5 percent, or by 1 million barrels a day (mbd), to 22.3 mbd, prices have remained stable. The reasons for this are: low demand from the industrialized countries, mainly the United States, due to slowed economic activity; seasonally slack use of oil for heating, or gasoline for longer-range driving in the spring; and the still-abundant stocks that were built up before and during the winter, which turned out to be a mild one.

The outlook for stable prices appears favorable in the near to medium term. The return of some Kuwait production by next year and the greater production capacities recently installed or upcoming should more than offset declining outputs in the United States and USSR. The largest oil importer - the United States - has cut imports by more than 1.5 mbd since early last year. U.S. domestic production currently exceeds net imports by more than 1 mbd, in contrast to only a year ago when net imports topped domestic production by almost 1 mbd.

Interest Rates

Fear of inflation and excess demand for funds in Germany have resulted in higher real interest rates in that country and in all the members of the European Monetary System. Only by official currency devaluation can they find room to cut interest rates and revive flagging demand. In Japan, slower money supply growth to ease inflationary pressures pushed short-term interest rates from half of U.S. rates in early 1989 to current levels of almost 2 percentage points higher than U.S. rates. Real interest rate differentials of more than 2 percentage points favor the Japanese yen, and the German mark by 4 points, over the U.S. dollar.

These real differentials were behind the yen's appreciation in the last three quarters of 1990 and the D-mark's appreciation since 1989. The recent depreciation of these currencies against the dollar may have to do more with discounting prospectively weaker German and Japanese economies, and the perception of the imminent revival of the U.S. economy. The ebullient equity markets in the United States, partly in response to lower short-term interest rates, have also helped strengthen the dollar.

The demand for capital in the Middle East - for war-related reconstruction and for renewed weapons purchases - will divert some funds demanded in Central Europe and the USSR as well as in hard-pressed LDC's. Also, the global supply of funds eventually will be tapped by U.S. companies in a reviving U.S. economy. These demands will most likely put upward pressure on interest rates once again, because former capital exports by Germany and exports of oil and petroleum products in 1992 is the principal reason for the latter's retreat.

Led by the newly industrialized countries of East Asia, Asia's real GDP growth is expected to exceed 6 percent in 1992, the highest since 1988's performance. Export growth of almost 14 percent is driven by continued strong inter-regional demand and especially by Japan's doubled import growth in 1992 from 1991. In Africa, lower economic activity in Algeria, Egypt, Nigeria, and only marginal gains in South Africa, should keep the continent growing sluggishly in 1992, by far the slowest among the LDC's.

Central Europe and

the USSR

Only Poland is expected to register a positive output gain in 1991 in Central Europe. The slow transition to market economies has been hampered by the low rate of foreign investment, except in Hungary, where about half of the region's large investments have been made so far. In Poland and Czechoslovakia, foreign investments are generally in small importing and exporting businesses. When commercial laws are introduced, the bureaucracy is streamlined, infrastructure is improved, and restrictions on repatriation of hard currency profits are minimized, cash inflows are more likely to accelerate.

The unrestricted movement of payments - the freedom to acquire and transfer not only foreign goods and services but also foreign currencies - entails currency convertibility. Convertibility will subject domestic producers to competition from abroad and at the same time import a system of economic pricing. The demand for foreign exchange has risen with the deterioration of terms of trade and export earnings as a combined result of the Persian Gulf crisis and trade conducted in hard currency with the USSR. Without the preconditions of macroeconomic stabilization, demonopolization, well-defined and enforced property rights, and freely flexible domestic prices, currency convertibility will exacerbate unemployment, raise inflation, and pressure wages and interest rates upward.

World Trade

The EC has proven to be an attractive market for U.S. goods as it pulls in imports because of dollar depreciation in 1990, and also as U.S. goods displace formerly high German exports, much of which have gone to eastern Germany and Central Japan have dried up due to the shrinking of their current account surpluses. It is predicted that real interest rates will average more than 4 percent in 10 industrialized countries between 1991 and 1995, in part because of overall lower savings.

Exchange Rates

The dollar's recent appreciation will be difficult to sustain until the perceived revival of the U.S. economy actually comes about. In apparent reaction to expectations, the foreign exchange market has shifted much favor from the D-mark to the dollar and less so against the yen. Apprehension surrounding the political survival of the USSR is also contributing to jitters about holding German marks. An additional demand for dollars has been the continued growth of U.S. exports, given relatively strong foreign economic activity. As long as the dollar's exchange value stays below estimated purchasing power parity rates, the medium-term prospects for U.S. exports should be favorable. The recent strength of the dollar, however, might spur import demand, even if the U.S. economy recovers only slowly.

Like the United States in the early 1980's, Germany is entering this decade with a tight monetary policy and expansionary fiscal policy. In the absence of sufficient internal financing, these should similarly lead to the U.S. experiences of a deepening current account deficit and an overvalued currency. Correspondingly, higher interest rates in the EC would be detrimental to world credit supply, especially to the Community's eastern neighbors. In contrast, Japan's narrowing external surplus reflects the internal adjustment of investment growth to high savings. Consequently, the exchange value of the yen rose against the dollar in 1990 and has not back-tracked as much as the D-mark has in recent months.

To sustain foreign capital's attraction back into dollars, U.S. interest rates must rise relative to German and Japanese rates, and the respective gaps in inflation rates must narrow. As the economies of Germany and Japan slow, interest rates are expected to follow, as evidenced in already lower bond yields relative to short-term rates. If the average current account balance of the seven big industrial economies falls to only 0.6 percent of their collective GNP in 1991, as forecast, more stable exchange rates are likely to emerge. And if the demand for capital by the United States continues to subside, the supply of funds to the Middle East and Central Europe should correspondingly ease.

Table : World real economic growth

Calendar year           1990   1991   1992
                   Percent change
World                   1.3    1.0     3.3
  World less U.S.       1.4    1.4     3.3
Developed countries     2.4    1.3     3.1
  DC's less U.S.        3.3    2.0     3.1
  United States         1.0   -0.4     3.2
  Canada                0.9   -0.5     3.9
  Japan                 5.6    3.1     3.8
  EC-12                 2.8    1.7     2.9
Developing countries    1.8    2.6     5.3
  Latin America        11.1    1.5     3.6
    Mexico              2.6    3.4     4.6
  Asia                  5.5    5.9     6.2
    South Korea         9.0    7.8     7.8
    Taiwan              5.1    5.8     6.8
    China               4.4    5.7     6.3
  Middle East          -6.5   -7.9     8.8
  Africa                2.9    2.8     2.6
Central Europe         -6.2   -4.4    -0.5
  USSR                 -4.8   -5.1    -1.0

Sources: History: IMF, International Financial Statistics Yearbook, country projections: Project LINK (March 1991).

COPYRIGHT 1991 Superintendent Of Documents
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