Growth in the developing countries remained close to 6 percent in 1995 despite a marked slowdown in Latin America in the wake of the Mexican financial crisis. In 1996 and 1997, aggregate growth seems likely to remain in the 6 percent region as Mexico and Argentina recover, growth in Africa strengthens, and the expansion moderates in a number of Asian emerging market countries. Activity in emerging market countries is generally expected to remain buoyant on the basis of strong domestic fundamentals and continued large capital inflows, especially of foreign direct investment. In parallel with their remarkable success in expanding exports—both to developed economies and to each other—these countries have become the most dynamic markets for exports from the industrial countries. This has helped to offset the recent weakness in economic activity in many industrial countries, at the same time as strengthened international competition has contributed to the alleviation of global inflationary pressures and to the improvement of living standards worldwide, particularly in those countries that have adjusted quickly and flexibly to changes in relative prices and in their comparative advantages.

The role of domestic policies in fostering conditions conducive to rapid growth in the successful developing countries carries important lessons for those countries where progress has been more limited and that continue to fall behind in relative income positions. Among the strong performers, fiscal imbalances have generally been well contained and the role of the public sector has been mainly geared toward promoting private sector development. Disciplined fiscal policies in turn have reduced the need for monetary financing of budget deficits and facilitated the maintenance of low inflation, which is in single digits in many of these countries. And a stable, predictable macroeconomic environment has provided incentives to save and invest while heavy reliance on market forces, including through the pursuit of outward-oriented trade policies, has helped channel resources toward their most productive uses.

In contrast, although situations differ considerably and it is difficult to generalize, the less successful countries are often characterized by persistent fiscal imbalances exacerbated by loss-making public enterprises; by extensive government intervention in the economy through regulations and restrictions on the private sector and on foreign trade; by poor control of inflation; and by financial repression and the structurally negative real interest rates associated with it, which discourage saving and distort resource allocation. Experience shows that the sustained implementation of policies to address such shortcomings does, over time, lead to substantial improvements in economic performance.

One of the most pressing issues in many emerging market countries has been the question of how they should deal with the risk of overheating, which can result in unsustainable macroeconomic imbalances, rising inflation, and strains in financial markets, and ultimately affect the confidence of domestic and foreign investors. The importance of addressing such problems at an early stage is underscored by concerns about the vulnerability of banking systems to foreign exchange and financial market crises and domestic policy reversals, particularly when corrective policy actions are implemented belatedly. In the past several years, a number of emerging market countries have experienced disruptive and costly banking crises, and the fragility of banking systems in many other countries suggests that similar difficulties may occur in the future. To reduce such risks, the emerging market countries need to enhance the soundness of their financial sectors through strong prudential standards and supervision. Appropriate measures and early action will help to limit the risk of contagion from difficulties originating in the banking systems of other countries.

So far, standard price indicators suggest that inflation is relatively well under control in most of the emerging market countries. But the combination of widening deficits on current account and rapid growth testifies to excess demand pressures—as opposed to problems of external competitiveness—in countries such as Indonesia, Malaysia, and Thailand. Moreover, preliminary staff work to assess the level and growth rate of output that appear to be consistent with stable inflation suggests that the current levels of activity in these countries may be above their sustainable long-term trends. These countries have already taken measures to restrain demand, but further action may be needed to avoid the emergence of excessive pressures on capacity and to contain external imbalances. Korea has also been facing a risk of overheating, although growth has been moderating toward a more sustainable pace and pressures on resources appear to be easing.

In China, growth has slowed from the unsustainable pace of the early 1990s and inflation has fallen to less than half the rate seen in 1994. Money and credit, however, have continued to expand at a rapid rate and more restrained financial policies, supported by a hardening of budget constraints in state enterprises, are required to sustain the favorable inflation performance. An intensification of state enterprise reform together with further trade liberalization and the removal of the few remaining restrictions on current account payments will help strengthen the role of market forces in resource allocation. Vietnam has made substantial efforts to move toward a market-based economy, and has achieved robust growth for the last five years and more recently, single-digit inflation. To sustain this performance, structural reforms need to be deepened, including through restructuring of state enterprises, and macroeconomic policies need to remain cautious, especially in view of the widening deficit on current account.

For India, while recent economic performance has been quite favorable, high real interest rates stemming from excessive fiscal deficits and supply-side bottlenecks are likely to slow long-term growth. Moreover, there are risks of rising inflation and external vulnerability unless these issues are forcefully addressed. As long as the fiscal deficit remains high—the overall public sector deficit is still close to 9 percent of GDP even with the modest adjustment planned for this year—it will be necessary to maintain a tight monetary policy stance. But the key to sustained strong performance is ambitious fiscal consolidation that would relieve pressures on prices and the balance of payments, free resources for productive investment, and provide a more conducive environment for needed structural reforms. In Pakistan, the recent deterioration in the current account and continued double-digit inflation pose a threat to the medium-term outlook. Fiscal adjustment and financial sector reform are critical to the enhancement of longer-term prospects.

In Latin America, Chile remains the most successful economy. With a moderation of growth in 1996 from the unsustainable pace of 8 1/2 percent in 1995, concerns about overheating have abated, but pressures on capacity continue to warrant some degree of monetary restraint. Brazil also has been successful in reining in inflation thanks to the Real Plan: in fact, inflation in the year to August 1996, at only 8 ¹/₂, was the lowest 12-month rate since 1973. Fiscal consolidation and structural reforms, especially trade liberalization, are essential to safeguard this progress on the inflation front and to permit stronger growth on a sustained basis. In Mexico, activity is now recovering following declines in output in the wake of last year's financial crisis, and there has been progress in containing inflation following the sharp depreciation of the peso. Sustained adjustment efforts should help to strengthen market confidence further and permit growth to become firmly established in the period ahead. Growth has also resumed in Argentina, which is currently enjoying the lowest inflation rate in more than fifty years. Following several years of political instability, financial market crises, accelerating inflation, and declining output, Venezuela has now begun to implement an economic program designed to restore confidence, reduce inflation, and set the stage for a resumption of growth in 1997.

The recent strengthening of growth in many African countries is promising and the implementation of stronger macroeconomic and structural policies should allow average growth to continue to improve and the overall inflation rate to decline further. Nevertheless, the region continues to face important policy challenges to enhance resource allocation and strengthen saving and investment. It is particularly encouraging that Benin, Côte d'Ivoire, Togo, and other CFA franc zone countries are seeing continued recovery following the strengthening of incentives and restoration of external competitiveness brought about by the 1994 devaluation and accompanying policies. Ghana, Kenya, and especially Malawi and Uganda are also experiencing gains in living standards on the basis of continued progress in domestic policies and notwithstanding the adverse effects of volatile commodity prices. In South Africa, economic policies have begun to set the stage for a gradual strengthening of growth performance although unemployment will remain relatively high for some time. Several other countries, however, including Nigeria, Sudan, and Zaïre, have made little progress in the formulation and implementation of appropriate stabilization and structural adjustment policies.

In the Middle East and Europe region, economic performance also remains uneven. Israel and Jordan are experiencing strong expansions—with Israel recently taking further action to avert overheating—as a result of strengthened policies and capital inflows stimulated in part by progress toward improved regional stability. Turkey experienced a strong recovery in 1995, but the sustainability of the economic expansion is threatened by widening fiscal deficits and rising inflation. Saudi Arabia and many other oil producing countries are making progress in adjusting to lower oil prices; fiscal deficits have been reduced substantially, but further efforts are needed to contain public expenditures and reverse the rising trend in levels of public debt. Egypt has made progress in deregulating the economy and liberalizing foreign trade. As emphasized in the policy program the authorities have put forward for Fund support, privatization of public enterprises, the strengthening of the financial sector, and reforms to further improve the tax system are needed to allow the country to grow at a faster pace. Morocco's economy has rebounded from last year's drought. The needed strengthening of stabilization policies will have to be complemented by stronger efforts at structural reform. In Algeria, where greater macroeconomic stability has been achieved, further structural reforms are needed to achieve sustained economic growth over the medium term.