The world economy and exchange rates

The World Economy and Exchange Rates

The outlook for the world in 1991 will be even slower economic activity than in 1990 because virtually all the developed countries face declining real output growth. Inflation will also subside significantly, with oil prices at or below 1990's $21 per barrel average, paving the way for a recovery in 1992. The impact of higher oil prices in the second half of 1990 on global GNP expansion was to accelerate the downward trend already underway. High interest rates in the major developed countries along with falling equity markets were largely to blame for the initial weakness.

In contrast, the developing countries as a group are expected to improve their overall performance in 1991 as Asia continues its output expansion and Latin America benefits from much lower inflation. The runup of crude oil prices in 1990 hurt fuel-importing countries, but produced a windfall for Mexico, Venezuela, and Ecuador. In the former group, real income losses will be reflected in lower domestic demand and less imports. Another factor is that lower U.S. interest rates in 1991 should alleviate high debt-service obligations in the severely indebted countries in Latin America, as elsewhere.

Developed Economies

The developed economies will experience lower aggregate demand in 1991 as business fixed investment and private consumption slow further. The sharp deterioration of real GNP growth - from 2.7 percent in 1990 to 1.7 per cent in 1991 - will adversely affect developing countries as developed-country import demand decelerates more rapidly than exports. Germany's fast declining trade surplus benefits its neighbors more than developing countries, except possibly oil exporters. Current account balances in the United States, Japan, and Germany will continue to shrink, thus removing one source of exchange-rate instability, and eventually reducing differences in economic growth rates among them.

The United States and other currently weak economies will probably recover more quickly than expected due to lower inflation trends, more stable oil prices, and lower interest rates. However, the reluctance of U.S. banks to extend commercial credit will push down total fixed domestic investment by 2 percent in 1991. A slowdown is also expected in Germany because high short-term interest rates caused by the rebuilding of East Germany will cut gross fixed investment and even government spending growth by more than half in 1991. In Japan, the pace of gross fixed investment will also fall significantly due to higher interest rates and the weak stock market.

The Developing Countries

Unlike the developed countries, the developing countries as a group face brighter prospects in 1991 as positive GDP growth rates are posted in Latin America and the Middle East. These two regions registered negative growth in 1990 due to runaway inflation in the former and sanctions imposed on Iraq and Kuwait. The anticipated improvement in economic activity for all regions through 1992 results from lower and more stable oil prices for the oil-importing countries and continued healthy growth in exports despite some slackening of import demand from the developed countries in 1991. Recent efforts toward greater market orientation of industrial and trade policies also contribute to the optimistic outlook.

External financing for both trade and infrastructure is not expected to shrink because of much greater reliance on official and multilateral loans than on commercial lines of credit, which apparently have virtually dried up. However, since official loans usually require stabilization and liberalization measures, short-term benefits are limited in comparison to medium or long-term prospects. As in the developed countries, the outlook for 1992 looks even brighter as inflation, particularly in Latin America, becomes less of a problem.

Third-World Debt

Net capital transfers to developing countries in 1990 turned positive for the first time in 6 years, reaching an estimated $9.3 billion. Assistance was mostly from official sources and the number of grants and concessional loans grew, while the number of nonconcessional loans from bilateral sources fell. The dependence on commercial banks is reduced not only because of the banks' refusal to extend more loans, but also because the Brady Initiative is geared more toward reducing exposure to commercial loans and less toward reducing indebtedness to official sources. Outside of the Brady Initiative, several countries have reduced commercial bank debt significantly through swaps of debt for private equity.

Nevertheless, the debt crisis is far from over - total external debt of all developing countries rose by 6.3 percent to $1.34 trillion in 1990, and debt-service payments will rise by 13.4 percent in 1991 to $190 billion. However, the ratio of external debt to GDP is projected to fall below 30 percent for the first time in more than a decade. If the debt-to-exports ratio keeps falling (from its peak in 1986), then debt service as a percentage of exports will continue to decline despite the rise in average interest costs. Another encouraging trend is the growth in net long-term resource flows, including foreign direct investments, to about $70 billion in 1990.

Central Europe and

The USSR

Output declined in 1990 in all of these countries, which as a group will be in recession for at least the next 2 years. Because of far-reaching reforms, Poland suffered the steepest recession. This year, the USSR will be the worst case not only because of falling production, but also because inflation is increasingly widespread. The phasing out of former trade agreements in the region will cause the external position of Central Europe to deteriorate by almost $10 billion against the USSR, and cause trade to decline by 30 percent. The terms of trade will universally deteriorate in Central Europe as transactions with the USSR shift to world market prices in convertible currencies.

Inflation will generally remain intractable as long as the overhang of money balances is kept intact by price controls, subsidies, and rationing. The absence of monetary reform to reduce the actual stock of money also provides little incentive to cut budget deficits. And as long as private property rights and privatization are not fully established, foreign direct investments might largely be limited to joint ventures. Furthermore, trade liberalization is crucial in breaking domestic monopolies and in gaining efficiencies from the division of labor. Trade expansion is critical not only for economic growth but also to crub external debt growth. If current efforts to write off outstanding official debts are successful, foreign direct investments should expand.

World Trade

The value of exports and imports in the developed countries will slow only slightly in 1991, given stronger trade activity in Japan and only moderately lower activity in Germany and in North America. Export performance in the developing countries, led by Asia, Latin America, and the Middle East oil exporters, will improve from 1990's 14.5-percent increase to almost 17 percent in 1991. Oil exporters are expected to quickly raise imports in response to higher oil revenues, thus absorbing a sizable portion of exports of other developing countries. Moreover, the improvement in the U.S. competitive position due to dollar depreciation in 1990 and early 1991 should further reduce the current account imbalances in the United States, Japan, and Germany. By 1992, the U.S. current account deficit and the Japanese and German surpluses are projected to narrow to about 1 percent of GNP in each case.

The impact of higher oil prices on overall trade prices was muted somewhat outside the United States in the second half of 1990 because of dollar depreciation. Trade prices are projected to rise over the next 2 years by 3.5 to 5 percent compared with less than 2 percent in 1990, partly as a result of higher fuel prices and greater demand. Market prices of nonfuel commodities dropped 8 percent in 1990 and are not expected to recover in 1991. Prices of manufactured products should benefit from the increased demand because their share of total world merchandise trade now exceeds 70 percent. The lagged effects of dollar depreciation since mid-1990 on non-U.S. prices will take up to a year to complete. Hence, by 1992, some retrenching of import demand due to higher prices of trade goods is expected to slow world trade.

Oil Prices

World crude oil prices have retreated from a peak of $33 per barrel in October 1990 to under $18 in early February 1991, a 46-percent decline. Nevertheless, current price levels are still 20 percent higher than the $15 in July 1990, before the Persian Gulf crisis. The combination of high OPEC production and 5-percent-lower petroleum demand in Organization for Economic Cooperation and Development (OECD) countries, particularly the United States, reduced the chances of repeating past worldwide recessions following a temporary oil shortage. The supply situation is bolstered by the highest levels in OECD oil stocks - over 1 billion barrels, not including petroleum reserves.

In the United States, net oil imports of 6 million barrels per day (mbd) are well below domestic production levels of 7.4 mbd. As recently as August 1990, oil imports exceeded domestic production by almost 500,000 barrels per day. The impact of last year's higher oil prices on U.S. and other OECD inflation rates was not as severe as previous escalations because of the relatively small price rise and already slowing world inflation and demand. In addition, the energy consumption per unit output of OECD economies has decreased significantly since the first oil crisis in 1973. For 1991, western oil consumption is likely to average below 38 mbd, whereas demand in non-OECD countries is forecast to rise 3.5 percent to 15.8 mbd, enough to raise world demand by 1 percent.

World Credit Supply

The demand slowdown in the major economies, and last year's double dose of weaker equity prices and lower real household wealth, particularly in the United States, and probably lower land prices in Japan this year, will curtail spending and should encourage the buildup of personal savings. Moreover, as the dependency ratio - the population aged under 15 and over 64 - in the developed countries declines in the next decade, household savings are expected to increase. Thus, the prospects for global savings from private sources should be boosted. However, the budget deficits in Germany and the United States, which will probably rise again as the economic slowdown cuts tax revenues, are a drain on the savings pool.

Short-term interest rates in Germany and Japan are substantially higher than recent historical levels. Their low inflation rates boost real yields on short-term investments and keep long-term rates lower than they otherwise would be. These should contribute to the prospects for a higher savings supply. Weak spending in the United States should also help the availability of funds in spite of much lower U.S. interest rates. The refusal by commercial banks to lend to heavily indebted developing countries would likewise keep the credit supply intact until the anticipated recovery of world activity in 1992. Finally, the struggling economies of Central Europe and the USSR are apparently unprepared to absorb a large infusion of funds until structural reforms are fully in place.

Exchange Rates

U.S. short-term interest rates are now 1 percentage point lower than they were only last December, exacerbating the differential against higher German and Japanese rates. While the dollar has depreciated only moderately since then against the mark and the yen despite its lower money market yields, it faces increasing downward risks should U.S. interest rates fall further, or if German rates resume their climb. Real short-term yields in the United States are also much lower than in Germany or Japan, where economic activity remains strong. Since long-term U.S. rates exceed short-term rates and German and Japanese yield curves are inverted, the dollar will likely slide some more before recovering or stabilizing - in anticipation of a turnaround in the weak U.S. economy and the awaited weakening in Japan and Germany.

Relative to Germany, money supply growth rates in the United States and Japan were much slower in 1990, a reflection of lack of demand brought on by the U.S. recession and anemic equity markets in Japan. These developments, along with the diminution of respective external account balances, should provide a counterweight against the rising U.S. budget deficit, and thus against imminent upward pressures on U.S. interest rates.

Moreover, the shrinking U.S. current account deficit eliminates one important reason why the dollar needs to stay cheap. The yen might even benefit from lower interest rates - so long as U.S. rates do not rise at the same time - if fears of a possible collapse in land prices subside, thus avoiding another shakeout in Japan's stock market. Because of the alignment of exchange rates in the European Community, the U.S. trade surplus with Western Europe appears secure, providing German interest rates remain high.

Interest rate differentials in Germany and the United States have recently widened, but monetary policy actions in Germany intended to slow growth there, along with Federal Reserve moves to revive growth in the United States, should lead to their narrowing. But the revival of the dollar revolves more around the question of when, give uncertainties about escalating costs of unification in Germany and the severity of the U.S. economy's downturn. The preeminence of domestic needs will largely dictate monetary policy in both countries, thus shunting exchange rate stabilization to secondary status for the time being.

COPYRIGHT 1991 Superintendent Of Documents
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