I. Global Economic Prospects and Policies

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World economic growth quickened during 1996 following widespread deceleration of activity in 1995 (Chart 1). Economic and financial conditions are generally propitious for the global expansion to continue in 1997 and the medium term at rates at least matching those seen in the past three years (Chart 2). There are few signs of the tensions and imbalances that usually foreshadow significant downturns in the business cycle: global inflation remains subdued, and commitments to reasonable price stability are perhaps stronger than at any other time in the postwar era; fiscal imbalances are being reduced with increasing determination in many countries, which should help contain real long-term interest rates and foster higher investment; and exchange rates among the major currencies appear to be generally consistent with broader policy objectives.

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In many countries, structural reforms are enhancing the role of market forces and thereby strengthening the basis for sustained, robust growth. The process of trade integration continues to deepen and is being supported by growing liberalization of external payments. Also, changes in the role of the state through privatization and deregulation are raising efficiency and spurring private sector activity in a growing number of successfully managed economies in all regions.

The favorable global economic conditions are underscored by the continued robust growth performance with low inflation in the United States and the United Kingdom, the pickup in growth in Japan in 1996, and improved prospects for a strengthening of the recoveries in continental Europe and Canada. In many of the dynamic emerging market countries, there was a desirable moderation of growth and inflation in 1996, which should allow their expansions to be sustained in the period ahead. Growth has picked up in those developing countries in the Western Hemisphere that were particularly affected by the financial crisis in Mexico in 1995. Activity has also strengthened in the Middle East and Africa, while the transition countries, as a group, are expected to register positive growth in 1997 for the first time since the collapse of central planning.

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Nevertheless, despite these grounds for optimism, it is important to recognize that contrasts in economic performance across countries have become starker in recent years. There are also a number of risks to the central scenario. First, in much of the European Union (EU), unemployment has risen further to new postwar peaks, and neither prospective growth nor the progress made with labor market reforms gives reason to expect any significant decline in joblessness in the near future. High unemployment and weak growth could make it difficult for EU members to fully meet the fiscal deficit targets associated with the plan for monetary union, affect expectations about the likelihood of the project going ahead on time, and lead to turbulence in financial markets.

Second, stock markets. The strength of equity prices in the United States and many other countries in the period up to early March was a reflection of investors' positive assessment of the business outlook. But recent declines in equity prices have underscored the risk of a more significant correction, especially if earnings expectations were to be downgraded or a reemergence of inflationary pressures were to require a marked rise in interest rates. The potential for a market correction large enough to contribute to a cyclical downturn depends partly on the extent to which the rise in stock prices has been an element in a broader buildup of demand pressures. In contrast to the run-up in asset prices in the late 1980s, especially in Japan but also in the United States and several other countries, a generalized overvaluation of asset prices, leveraged by increased indebtedness, does not appear to be present in most countries with strong stock markets. Nevertheless, a significant decline in stock prices could undermine confidence in some countries.

Third, capital flows to emerging market countries. The surge in such flows in recent years reflects both the growing shift to a more open global financial system and the successful economic policies of many recipient countries. But caution is warranted since both the global availability of these flows and their cost are vulnerable to higher global interest rates and to adverse developments affecting systemically important capital-importing countries. While the aggregate global flows do not seem excessive, the reliance on capital inflows by some countries, and the associated narrowing of their interest rate spreads, may not be sustainable.

Finally, fragile banking systems are of concern in a broad spectrum of countries. These problems often stem from excessive credit expansion in the past under conditions of inadequate prudential supervision. In some emerging market countries, banking sector difficulties linked to significant exposure to foreign exchange risk have become more apparent following the reversal of capital flows from abroad. Among transition countries, bank loans have often allowed enterprises to delay restructuring, and as a result many firms have become increasingly unable to service their debt. Large portfolios of nonperforming loans, the erosion of banks' capital bases, and outright banking crises can affect countries' economic performance by obstructing banks' ability and willingness to lend, by constraining The operation of monetary policy, and because of the budgetary costs of rescuing and restructuring ailing financial institutions.

It is becoming increasingly clear that the benefits of a favorable global economic environment do not accrue automatically to any country. In fact, remarkable differences persist in the degrees of success that countries have had in taking advantage of the opportunities for strengthening their economic performance.

• Among the advanced economies, developments have been mixed and cyclical positions differ widely. Prospects for recovery have improved in continental western Europe following disappointing performances in 1995 and much of 1996. But unemployment is expected to remain at or near record levels in France, Germany, Italy, and several other countries. In Japan, growth was stronger than expected in 1996, and there is upside potential for activity in 1997 although there remains uncertainty in financial markets, in particular, as to whether the momentum of Japan's recovery will be maintained in the period ahead. The uncertain prospects and lack of confidence characteristic of these economies in recent years contrast with the favorable performance of the United States and the United Kingdom as well as a number of smaller countries including Australia, Denmark, Ireland, New Zealand, and the Netherlands. These contrasts reflect both cyclical and structural factors, including policies.
• An increasing number of developing countries in all regions are reaping the benefits of the steadfast pursuit of sound financial policies and outward-oriented, market-based structural reforms. This is reflected in large inflows of foreign direct investment, rapid expansion of both exports and imports, and solid growth prospects. But some countries have experienced setbacks and others are vulnerable to changes in investor sentiment. While economic conditions have clearly been improving in a growing number of low-income countries, many of the poorest countries have continued to fall behind, facing the risk of marginalization from the mainstream of global economic progress.
• Among the transition countries, the contrasts in performance have also widened between some of the early, relatively successful reformers and countries that have started adjustment and reform later and with less determination and consistency. Between these two extremes, which, to be sure, also reflect widely different starting conditions, there are wide ranges of policy effort and economic success.

Motivated in part by these contrasts, the Interim Committee in its September 1996 "Declaration on Partnership for Sustainable Global Growth" set out a range of broad policy principles to promote the full participation of all economies in the global economy. These principles stress the need to implement sound macroeconomic policies that consolidate success in bringing inflation down, strengthen fiscal discipline, enhance budgetary transparency, and improve the quality of fiscal adjustment; to foster financial and exchange rate stability and avoid currency misalignments; to maintain the impetus toward trade liberalization and current account convertibility; to tackle labor and product market reforms more boldly; and to ensure the soundness of banking systems and promote good governance in all its aspects. The complementary and mutually reinforcing roles of macroeconomic and structural policies were given particular emphasis.¹

The uneven performance across countries and uneven distribution of rewards within them are frequently linked to the phenomenon of globalization—the rapid integration of economies worldwide through trade, financial flows, technology spillovers, information networks, and cross-cultural currents. There is no doubt that globalization is contributing enormously to global prosperity. At the same time, however, public debate often focuses on perceived negative aspects of globalization, including the effects on employment and real wages, especially of the low skilled, in the advanced economies. Globalization, like any form of technological or structural change, may adversely affect the living standards of some in the short run. However, it does not seem to be the principal force behind the unfavorable developments in employment and income distribution observed in some advanced economies.

Another widespread perception is that globalization may, at some cost, limit the autonomy of policymakers at the national level. It is argued in this report that while it does appear that globalization increases the costs of economic distortions and imbalances, policy related or otherwise, it clearly enhances the rewards of sound policies. In this way, globalization may be contributing to the apparent polarization between successful countries and those that are falling behind in relative, and sometimes even absolute, per capita income positions. Globalization is not, however, a zero-sum game with some economies winning at the expense of living standards and employment elsewhere. If policies are adapted to meet the requirements of integrated and competitive world markets, then all countries should be better able to develop their comparative advantages, enhance their long-run growth potential, and share in an increasingly prosperous world economy.

Globalization is not a new phenomenon. Highly integrated markets contributed to the rapid growth of trade and output during the period of the gold standard prior to World War I. But two world wars, the Great Depression, the adoption of central planning in a substantial part of the world economy, and the pursuit of protectionist and interventionist policies in many countries seriously disrupted international economic and financial interactions. The liberalization of trade and financial flows over the past fifty years has gradually resulted in a level of integration similar in some respects to that known at the beginning of the century—with plenty of scope for further integration as the next century approaches. This issue of the World Economic Outlook particularly focuses on the opportunities arising from globalization and on how countries may best meet the challenges of a rapidly changing and highly integrated world economy.