(Annual percentage change)
 
 

Source: UN/DESA.

Note: Two dots (..) indicate that data are not available.

Table I.2.

Growth of per capita output in developing countries, by region, 1996–1999

Effects on output of a strong recovery in Japan

Source: UN/DESA, based on Project LINK.

In the last quarter of 1998, largely because of a reduction in output in Germany and Italy, Europe experienced a deceleration of growth which is expected to persist into 1999. The slowdown, however, will be short-lived, in part because of the cut in interest rates in April 1999, together with buoyant consumer spending. Growth should be stronger in the second half of 1999 and so overall growth of 2 per cent in 1999 is likely to accelerate to 2½ per cent in 2000.

The unemployment picture in the developed countries reflected their growth performance (see table A.7). The unemployment rate in the United States has fallen to a level not observed since the late 1960s and is now lower than Japan’s, which has been rising. High unemployment persists in many countries of the European Union, but depends only to a limited degree on the business cycle. While there was some improvement in recent years, especially in countries with the highest rates, such as Spain, rates are still above 10 per cent in many European countries. The reduction of unemployment continues to be a major policy issue for the European Union.
 
 
 
 

Major uncertainties
 
 
 
 

Even though stability appears to have returned to global financial markets and the world economy, the past two years have demonstrated that globalization has increased the uncertainties and downside risks faced by individual countries and the world economy. These risks themselves are not necessarily associated with a group of countries; they can stem from a national problem that, because of today’s integrated world economy, has global consequences. The above forecast should thus be understood as subject to errors that could produce slower or faster growth than the forecasts show, albeit with a preponderance of downside risks.

One downside risk, possibly the worst, is that of a hard landing for the United States, either because of a stock market crash, which would reduce the wealth of economic actors, or because the authorities reacted to a sign of inflationary pressures by tightening monetary policy so sharply as to produce a decline rather than a moderate deceleration of output growth. What has hitherto been the main stimulus to world output could therefore go into reverse.

Among developing and transition countries, there are several downside risks: Brazil still faces a formidable task in addressing its large fiscal-sector imbalances; growth in China’s export sector is declining faster than expected and consumer demand is also weak; there is a risk of a further decline in output in the Russian Federation, especially given the uncertainty surrounding the Government’s economic policy and whether it will be able to achieve the required cutbacks in fiscal expenditures, increases in fiscal revenues, and structural reforms in the real and financial sectors. Setbacks in Brazil, China or the Russian Federation would have adverse consequences primarily for their neighbours and trading partners.

In order to examine one specific set of these downside risks, a study was undertaken, utilizing the models of Project LINK, of the possible impact on the world economy of another major financial crisis, on this occasion entailing a sizeable stock market correction and credit rationing, with currency realignments and shrinkage in international capital flows. The results (see box I.2) suggest that such a sequence of events would set off a severe contraction not only in developed countries but also, through their trading and financial links, in developing and transition economies. While the orders of magnitude in such a scenario depend on the assumptions made, the results indicate that world growth would slow down markedly and be accompanied by a further contraction in global trade. The impact on developing countries would be particularly pronounced. Because of the intensive trading and financial links between many of the economies in transition and the European Union, the former would experience a sharp drop in their growth rates as well.

Gross domestic product and world trade

(Percentage difference from the baseline^a)

At the onset of the Asian crisis, the scale and form of the contagion that subsequently took place were not envisaged and the policy responses were correspondingly disappointing. The actions taken initially followed traditional approaches, with adjustments being made as shortcomings were exposed. However, even these adjustments were often a venture into the unknown.

The period since the crisis erupted has provided new experiences and a new perspective to economic policy-making at the national level. Because of the increased interdependence in the world economy, there has been a change in the balance between domestic and international considerations in many national policy choices. However, the differences among countries and in their degree of integration into the world economy suggest that, although there are some common elements, the optimal policy choices will depend on country circumstances.

In this era of heightened financial volatility, the importance of sound macroeconomic fundamentals has become paramount: a sustainable fiscal position and current-account balance, a low or moderate rate of inflation, and consistency between the rate of inflation and the exchange rate are indispensable for any economy, as all economies are open (albeit to different degrees). Equally important, however, is the need for a number of structural and institutional conditions to be met in order to reduce the likelihood that growth will be interrupted by international or domestic financial crises.
The past two years have prompted much discussion about the desirable policies and targets for key macroeconomic variables, the actions necessary to avoid future crises and the trade-offs that have to be addressed in striking the correct balance in policy. In many of these cases, experience to date provides no definitive answer to the debate, other than that the response is likely to vary from case to case.
 

Macroeconomic policy and financial crises

 

A first question concerns the desirability of raising interest rates to the heights that were reached in crisis countries. Some increase in interest rates is inescapable, owing to the exit of funds from domestic financial markets. In general, policy makers in the crisis economies faced a dilemma. When exchange rates began to depreciate, monetary tightening was viewed as a means of preventing a depreciation-inflation spiral and of discouraging further capital outflows. However, it was recognized that monetary tightening would also seriously weaken economic activity and have other negative effects. In the recent cases, nominal interest rates were raised to very high levels and often kept there for a long period, giving rise to unusually high real interest rates. Nevertheless, exchange rates plunged.

 

Advocates of the high interest-rate policy argue that it was necessary to restore international market confidence in order to stabilize exchange rates. Opponents argue that this policy was not based on sound theory or evidence. They have shown that circumstances exist, and these may have characterized the situation in the Asian economies in crisis, when raising interest rates weakens the economy and leads to further currency depreciation. As such, this policy may have caused an unnecessarily deep recession, besides failing to stabilize the exchange rate.

Moreover, neither monetary nor fiscal policy excesses were the source of the crises that erupted in the Asian economies in 1997. These crises were caused largely by financial problems in the private, rather than in the public, sector; fiscal balances in most of these economies were sound, having been in surplus for many years prior to the crisis. Nevertheless, the initial policy involved adopting tight fiscal as well as monetary policies. This policy was eventually relaxed when the economic recession turned out to be deeper and more widespread than had initially been anticipated. There now seems to be some agreement that the extent of the fiscal austerity initially pursued by these economies was inappropriate.

Much of the deterioration in fiscal positions in 1998 was beyond the control of Governments. For commodity-dependent countries, the decline of commodity prices in international markets in 1998 led to significant reductions in public revenues. While the losses were particularly acute in oil-exporting countries, lower prices for non-oil commodities adversely affected many countries, mainly in Africa, that rely on international trade in commodities as a source of fiscal revenues. More generally, the necessary compression of imports, combined with longer-term programmes of reductions in tariffs as a part of trade liberalization measures, reduced tariff revenue, an important source of fiscal revenue in many developing countries. In addition, the overall slowdown in economic activity that took place in most economies tended to lower other government revenues.

In the Asian cases, increasing the fiscal deficit was an appropriate response to the crisis. In 1998, however, the widening of fiscal deficits was one of the causes of the crisis in the Russian Federation and Brazil. In considering this difference, a distinction needs to be made between the cyclical and structural portions of a country’s fiscal position.³ In the Russian Federation and Brazil, the deficits were structural and were likely to persist unless there were major policy changes. In the Asian case, the deficits have been cyclical and appropriate in order to stimulate economic activity, as well as to enable Governments to address some of the social consequences of the slowdown, and are expected to disappear as recovery proceeds.

For countries that are integrated into the world financial markets, views regarding the likely behaviour of market participants now play an increasing role in the determination of a Government’s fiscal options. This limits the room for manoeuvre that Governments have in using fiscal policy to address purely domestic policy objectives. Governments have to balance the perceptions of these markets with their own policy objectives and domestic political constraints. Because of the sensitivity of these markets, the costs of a loss of confidence and the time it takes to regain confidence, there is an inbuilt pressure on Governments to adopt restrictive fiscal policies. In 1998, Governments in most instances were under pressure to reduce fiscal deficits, despite the need to allow automatic stabilizers to take effect and possibly to complement them with an anti-cyclical relaxation of policy. In the Asian crisis countries, for example, it was only when the severity of the recession and its social consequences became apparent that fiscal packages involving tax cuts to prop up domestic demand and increased social expenditures were adopted. Elsewhere, in cases where the consequences of the crisis have been less severe, fiscal policy remains generally restrictive. However, as illustrated in the Asian cases, this may not be desirable domestically from either an economic or a social perspective. In the present era of slow global growth, it may also not be optimal from the perspective of the world at large.
 
 

Coordinated international measures to accelerate recovery
 
 

The international response to the crises in South-East and East Asia was essentially restricted to the provision of large-scale financial assistance intended to meet the crisis countries’ short-term needs for international liquidity. As indicated above, this financial assistance was initially accompanied by restrictive policies in the countries concerned but no changes in policies elsewhere were deemed necessary to address the consequences of the crisis. The result of this approach was not only a dramatic contraction in the countries concerned but also a slowdown in growth in the rest of the world. Particularly in the light of the present poor short-term prospects for the world economy, it is of interest to explore whether the use of international measures, rather than reliance purely on domestic action, might have achieved a more positive outcome for the countries concerned and, at the same time, might have boosted global economic growth.

One possibility could have been an internationally coordinated plan to cut interest rates in the major developed economies and increase official transfers to the Asian crisis economies. There are four reasons for such a set of policy actions.

First, the past two years have demonstrated that it is counter-productive for the global economy as a whole to have the initial burden of adjustment borne chiefly by the crisis economies through a tightening of aggregate demand. It would have been preferable if all countries with room for stimulating domestic consumption (such as the European economies) had contributed to the adjustment effort. The major European countries adopted measures of this nature when they started cutting interest rates beginning in the last quarter of 1998 in response to fears of a slowdown in their domestic economies. To the extent that this slowdown was a consequence of the initial crisis, these measures were a belated and indirect response to that crisis; if they had been taken earlier, the slowdown in their economies would probably not have occurred. In addition, the cuts were not coordinated at the global level (although they were coordinated within the Euro zone, even before it officially came into operation).

This presents a second reason for such measures, namely, that a coordinated interest-rate reduction would stabilize the differentials in interest rates among countries and would therefore be more efficient; it would also have fewer adverse side effects for the world economy than country-driven interest rate changes which largely ignore the impact on rates elsewhere.

Third, an external demand stimulus would have been more effective in promoting recovery of the Asian economies because an important part of the idle capacity that was created in these countries was oriented towards exports.

Fourth, an additional official transfer of resources from the developed economies to the crisis countries would have not only stimulated these economies, but also fed back positive demand impulses to the developed economies through trade and other links. Foreign demand could have provided a stimulus to domestic activity in cases where weak domestic demand has since proved resistant to stimuli.
 
 

Addressing the social and human dimensions
 
 

The policy measures adopted in response to the crises in the Asian countries, in particular, brought into sharp relief the need to ensure consistency between short-term economic objectives, such as financial stability, and longer-term social and developmental goals, such as the eradication of poverty and the development of human capital. In some instances, there may be no incompatibility between economic and social objectives but this is not necessarily the case. In the Asian crisis countries, the policies initially adopted to address the crises abruptly reversed much of the long-term progress that had been achieved in reducing poverty and improving social conditions. This experience underlined the need to ensure that the social dimension is integrated into the formulation of economic policies, so as to avoid treating any negative social effects as by-products to be addressed later.

Negative social consequences of economic policies can arise through a variety of channels. The prime example of this occurs when budgetary cutbacks introduced to restore macroeconomic stability undermine the ability to deliver health care and education and to provide safety nets (such as food subsidies for the poorest). However, monetary policy can also have social consequences; for example, tight monetary policy restricts the availability of credit, and this is likely to impinge more on small and higher-risk borrowers than on major enterprises. Higher interest rates may discourage new investment in productive capacity, thus negatively affecting prospects for increased demand for labour. On the other hand, one of the key objectives of restrictive policies is often to control inflation, and success in this area has direct benefits for the poor. In Indonesia, for example, inflation since the crisis has been a major source of the increase in poverty.

These social consequences of the crisis not only entail short-term human costs but also cut into the ability of the countries concerned to build up their human capital and lift their standards of living over the longer term. For example, both declining school enrolment and worsening nutrition among children reduce the potential of those individuals to contribute to the economic and social development of their societies over the longer term.

The international community has long accepted the principle that the social and economic dimensions of policy should not be treated in isolation. Implementing that principle, however, has proved elusive. It is now increasingly recognized that the response to crises has to address the domestic social consequences of any economic measures that are adopted and should not be restricted to restoring macroeconomic stability and international financial confidence. Various social safety nets have been introduced in the crisis countries as a result. However, it has also become apparent that social protection mechanisms are more effective if they are in place before a crisis strikes than if they are hastily put together after a country faces a severe recession. The social dimension therefore needs to be incorporated in economic policy as a matter of course.
 
 

Strengthening the financial architecture
 

The crises of the past two years are attributable less to traditional macroeconomic imbalances than to vulnerabilities that arose from the way financial liberalization had been pursued and the phenomenal growth of private sector exposures to large amounts of risk which were underappreciated and not very well understood. The result has been widespread recognition of the need to devise new financial regimes which would be less susceptible to these types of crisis. This policy initiative has domestic and international dimensions and has come to be called "renewing the international financial architecture".⁴

As a first principle, it is universally accepted that the governance of financial markets and institutions must be strengthened in developed, developing and transition economies, albeit without assuming that one set of practices fits all situations. Private financial institutions need to be able to cope with volatility in the markets in which they operate. This means having capital adequate to their risk exposure and the capacity to monitor and manage their risk. The role of government is to establish incentives and sanctions that force financial firms in this direction. This entails strengthened regulation and supervision, bankruptcy and foreclosure laws, corporate transparency and governance.

These improvements require the development of human and institutional capital in most developing and transition economies, which takes time. For this reason, financial sector liberalization needs to be paced with the build-up of regulatory capacity and appropriate professional and managerial capacity in financial institutions. This implies that the appropriate pace of liberalization will be determined by the country’s stage of development and capacity to make effective use of international expertise in both private and public sectors.

Governments need flexibility in considering the use of controls on movements of capital into and out of their economies, in particular as regards short-term flows. Views differ on the usefulness and effectiveness of different types of capital controls and no single model will be appropriate for all countries. Thus, the international community should not discourage countries from adopting policies to inhibit potentially volatile inflows and outflows. The experience of the past few years is an argument for experimentation and against dogmatism.

The damage that can arise when the uncertainty of private financial actors turns to fear and flight is much better appreciated than before. To lessen uncertainty, Governments and the International Monetary Fund (IMF) have worked recently to increase the amount of information in the public domain and the speed with which it is provided. International organizations have also enhanced cooperation so as to provide more reliable information, such as on financial flows and debt, and to do so more quickly. These are important initiatives that need the support and participation of creditor and debtor countries, of Governments and the private sector.

The policy community has become sensitive to the expectations of international private creditors that they would be bailed out by the international public sector when currencies and banking systems of emerging market economies went into crisis. Those expectations caused excessively risky lending practices — the "moral hazard" problem — and huge bailouts (financed at market interest rates and substantial cost for most countries). The international community is seeking to develop mechanisms to involve creditors in the working out of a future crisis and to reduce moral hazard by asking creditors (banks and bondholders) to shoulder more risk. Beyond general principles, however, there is little agreement on mechanisms or instruments to effect this change. This is an important area for further work.

At the same time, the international community favours providing adequate liquidity to countries in crisis, especially when these countries have followed sound policies and are hit by contagion from a crisis that is spreading internationally. A step was taken in this direction in April 1999 when IMF agreed to establish the Contingency Credit Line. Countries that meet certain policy criteria will be able to arrange a line of credit at IMF from which they can draw on short notice in the event of a financial emergency stemming from international developments beyond their control. This is to supplement their primary line of defence, holdings of their own reserve assets.

Beyond these policy developments, there has been a new intellectual ferment in respect of trying to better understand how financial sectors operate. It is clear that the financial sector in developed countries has been evolving rapidly in recent decades, especially the banking systems. The liberalization drive in developing countries has plunged these countries into a new, highly competitive world of finance, as has the adoption of market-based financial systems in the economies in transition. Technology has so evolved that the uncertainties, asymmetries and market failures inherent in finance can wreak extensive damage with unprecedented speed, as we have been witnessing over the past two years. In order to help take stock of our understanding in this area, part two of the present Survey is devoted to an examination of financial development in the globalizing world.

        Note:

 1. Because population growth is faster in poor countries than in rich ones, there has to be an even larger difference
    between the rates of increase in total output in the two groups of countries.

2.  The outlook reported in the present Survey is partly based on Project LINK, an international consortium of global economic
     forecasts and policy analysis supported by the Department of Economic and Social Affairs of the United Nations Secretariat.
     Documentation of detailed forecasts and the policy assumptions can be found in the various reports prepared for the spring
     LINK meeting, which was held in New York, 3–6 May 1999. These documents are available on the Internet
     (http://www.un.org/esa/analysis/link).

3. For a discussion of alternative measures of the fiscal deficit, see World Economic and Social Survey 1997 (United Nations
    publication, Sales No. E.97.II.C.1 and corrigenda).

4. As a contribution to this project, the most senior officials of the United Nations Organization in the economic and social
    arena, through the Executive Committee on Economic and Social Affairs, prepared a set of proposals in a report entitled
    “Towards a new international financial architecture” (available on the Internet at
    www.un.org/esa/coordination/ecesa/eces99-1.htm).