Part 3 Statement by the Managing Director on the Report of External Evaluators on Fund Surveillance Executive Board Meeting, August 27, 1999
- International Monetary Fund
- Published Date:
- December 1999
Staff Response to the External Evaluation of Fund Surveillance
Statement by the Managing Director on the Report of External Evaluators on Fund Surveillance
Executive Board Meeting, August 27, 1999
1. Management has been asked by the Chairman of the Evaluation Group of Executive Directors to comment on the External Evaluation of Surveillance. We offer our views as a contribution to the in-depth debate the Executive Board intends to have as it seeks to strengthen the process of Fund surveillance. We welcome the report, and express our appreciation for the careful work and considered judgments of the panel. We will discuss the major recommendations of the report, but will not comment on other details of the text, beyond noting our general agreement with most of it. We note also the staff’s comments, which in our view constitute a considered response to the evaluation, presenting detailed reactions to and commentary on the individual recommendations of the evaluators. Our views differ at most in the nuances from those of the staff.
2. In paragraph 2 of their report, the evaluators usefully define six goals of surveillance: (i) policy advice; (ii) policy coordination and cooperation (among countries—but also, it becomes clear from the text, within countries); (iii) information gathering and dissemination (to member countries and the public); (iv) technical assistance (particularly in supplying macroeconomic expertise to smaller, developing countries); (v) identifying vulnerabilities (especially to governments, but also perhaps in the course of time to markets); and (vi) “delivering the message,” that is, disseminating professional conclusions on policy matters to members, an extension of the advice role. Of these, we regard the first goal, policy advice, and the third, information gathering and dissemination, as primary, and the others as derivative, or as implied by the policy advice and information roles.
We have ourselves been struck in our discussions with many members how much they value not only the Fund’s surveillance of their own economies, but also the information on the major economies and the world economy that they receive from the surveillance process; for countries not in the OECD, the great bulk of the membership, Fund surveillance provides their only systematic window on the world economy, and they value it highly. They value, too, the opportunity provided by Board discussion to comment on and seek to influence global developments and policies in the leading industrial countries.
3. The evaluators inject a valuable note of realism in their discussion of the impact of surveillance on a country’s policies, for instance in paragraphs 5 and 6 of Chapter V of their report. Outside the context of programs, Fund advice should be viewed as “an input that could on occasion be significant, depending upon the stage of the domestic policy debate” (Chap. V, para. 7). Similarly, to the extent that Fund surveillance documents are made public, they will frequently be only one voice among many commenting on the global economy or particular countries—though their relative importance increases for the smaller and systemically less important countries. These observations emphasize the necessity to ensure that the Fund’s analysis is first rate.
4. The report was written at a time when surveillance was undergoing major changes within the Fund, largely as a result of the crises of the last five years. Thus, as noted in both the evaluation itself and in the staff’s comments, some of the recommendations, including those relating to enhancing surveillance of the financial sector, capital account issues, and policy interdependence and contagion, are already in the process of being implemented. Similarly, the experiments on publication of Article IV reports will help the Board decide whether to accept the evaluators’ recommendations on publication of Article IV reports. Management supports publication, while recognizing that we need to find a way of publishing that takes account of valid concerns over the implications for the frankness of discussions with the staff, and possible market reactions.
We will next comment on the main recommendations of the report.
5. The authors recommend that we give greater emphasis to aspects of analysis that the Fund is particularly well equipped to provide: (1) aspects of the international financial situation most relevant to the member country; (2) relevant experience from other countries; and (3) how the member can best absorb whatever shocks might emanate from abroad (i.e., how to deal with vulnerabilities). This—including the emphasis on the analysis of vulnerabilities—is an excellent idea, which deserves greater emphasis in our surveillance activities.
6. Greater focus in Article IV consultations on the Fund’s core issues, macroeconomic and exchange rate policies, plus the financial sector. This recommendation runs counter to most of the pressure on us from the Board and the membership, who have given increasing emphasis to the interactions between macroeconomic and structural policies, ranging even beyond the financial sector. The evaluators base their recommendation in part on evidence that Fund advice outside the core areas is not regarded by the authorities as commanding the same authority as that on macroeconomic issues. The staff presents a careful response to the recommendation for more focus; we conclude, as they do, that while the core issues should continue to be at the center of the surveillance process, other areas will—depending on the country—have also to be included in the surveillance process. At a minimum, social sector issues and poverty will have to be discussed in most Article IV reports. In order to make surveillance in these areas more effective, the Fund will have to further strengthen its cooperation with other institutions, primarily of course the World Bank.
7. Article IV consultations for small and mediumsized industrial countries should be less frequent than annual. We recognize that the relative value added by the Article IV consultation to the policymakers in these countries, most of which are members of the OECD, is probably less than that in-developing countries that receive less attention from other agencies and financial market participants. However, we agree with the comments of the staff on this recommendation and add one more factor: that much of the strength of the Fund as an institution derives from the symmetry with which countries are treated in the surveillance process, with each country having the right to comment on economic policies in every other country. We will need to consider the possibility of less frequent Article IV consultations for small and medium-sized industrial countries on a case-by-case basis, taking into account both the country’s views on the desirability of annual surveillance for itself, and the views of other countries on the benefits of such surveillance.
8. Regional surveillance should receive more emphasis. We welcome the suggestions in this area, and accept responsibility for the fact that staff presentations in country matters sessions do not have a regional focus: management has hitherto taken the view that given the particular orientation of these sessions, it would be more appropriate to concentrate on country-level problems. There are two senses in which the term regional surveillance is used: first, that common policy issues and spillover effects should receive more attention; and second that, as in the EU, analysis should be focused more on region-wide rather than national aggregates and policies. We agree that regional surveillance in the first sense deserves greater attention; and take up the case of the EU next.
9. The panel recommends that surveillance of EU countries be carried out mainly at the EU level, as is now being done for monetary policy for the EMU countries. We believe that surveillance for EU countries will move toward the EU level over the course of time, as other aspects of decision making move in that direction. Meanwhile, as we maintain country-level surveillance for EU countries, we need to consider whether too many resources are being devoted to that effort.
10. The panel recommends quarterly publication of the World Economic Outlook (WEO). We do not support this suggestion, which would be intensive in staff and Board time, preferring rather the approach taken so far of bringing out a special issue of WEO when needed. We could, however, support more frequent (than annual) publication of capital markets information, including possibly through expanding the quarterly report on capital flows sent to the Board by the Research Department. On the issue of WEO projections, we see great value in the present iterative process in which the area departments and the Research Department evolve towards a mutually acceptable view. (We note for the record the high regard for the WEO and International Capital Markets report shown by the evaluation group.)
11. The review process. This problem is discussed also in the evaluation of research. We have undertaken several internal reviews of the review process. The review process is an essential contributor to the creation of a coherent Fund position on issues. However, we do need to find a way of reducing the amount of resources devoted to it; that can be done in part by ensuring that departments concentrate on their own areas of expertise, with “no comment” becoming a fully acceptable and frequent comment.
12. Role of the Board. While this is by and large a matter for the Board to consider, we have the following three observations.
- In making the recommendation for a committee structure, the evaluators do not take account of the varying levels of participation of each chair at different meetings. The Executive Directors or their alternates tend to take part in the most important meetings, or those of particular interest; advisers and assistants take part in other meetings. This arrangement ensures the benefits of the committee approach, without removing the right of individual countries to take part in all discussions.
- For several reasons, most practically given time pressures, we would be reluctant to bring briefing papers to the Board for discussion; one way for the Board’s concerns in a particular country consultation to be brought to the attention of the staff is for the Executive Director to ask colleagues before each mission whether there are issues that in their view deserve special attention, and then inform the staff.
- The experiments now under way to increase the efficiency of Board discussions could also help focus surveillance.
Staff Response to the External Evaluation of Fund Surveillance
1. The evaluators have produced a candid and comprehensive report. It is realistic about what surveillance can—and cannot—achieve, and it provides an historical overview of surveillance at the Fund that is informative even for knowledgeable readers.
2. The evaluators’ main findings—summarized in their executive summary—have much in common with the views of Fund staff. Many of the prescriptions of the report—notably, better regional surveillance and a stronger international dimension to bilateral surveillance; and greater emphasis on financial sector and capital account issues, external vulnerability, policy transparency, and the dissemination of timely information—are already on the Fund’s agenda. Staff broadly agree with the thrust of the recommendations in these areas.
3. Staff welcome the largely positive evaluation of the conduct of both bilateral and multilateral surveillance in core areas. Staff also appreciate the questions raised about the institution’s capacity to deal adequately (in the context of bilateral surveillance) with nonfinancial structural issues and the related concern that the expanding coverage of these issues could detract from the overall effectiveness of surveillance. The focus of surveillance is an issue with which the staff have also been grappling, and we share many of the concerns raised by the evaluators. Improving work on nonfinancial structural issues, strengthening financial sector and capital account surveillance, and incorporating more of the various international and regional dimensions of a country’s macroeconomic situation into the Fund’s bilateral surveillance without reducing the quality of surveillance pose a major challenge—especially in light of the increasing demands on staff from other areas of work and stringent resource constraints. Nevertheless, most staff recognize the analytical necessity of the broadening of surveillance to cover certain areas that are critical to assessing member countries’ situations. To focus bilateral surveillance solely on the exchange rate and directly associated macroeconomic policies, as the report recommends, risks missing important issues and misreads the needs and demands of the Fund’s membership.
4. On methodology, many staff members would have liked to see more space devoted to the methodological underpinnings of the work leading to the conclusions and recommendations. Relatedly, there are comments and suggestions that arose from the interviews that staff found particularly thought provoking—for example, concerning the forecasting record of departments, the use of cross-country comparisons in bilateral surveillance, staff advice on fiscal consolidation, and the emphasis on first-best solutions. However, these were based on limited observations and it was difficult to gauge their relevance to the Fund’s work more broadly. The points advanced in the report on these issues/merit more systematic examination, including in the context of the Fund’s internal work.
5. On process, the staff read with interest many of the observations on the Fund’s internal organization. Many of the proposals in the report, including those concerning a shift of the responsibility for WEO projections to the Research Department, the internal review process, and the role of the Board, have important implications for the Fund’s internal processes and would need to be explored further before these proposals can be properly evaluated. This view is revisited in some of the sections below.
6. The response that follows focuses on several major themes and recommendations. The magnitude of the report dictates a need for selectivity in this effort. Thus, we touch upon issues related to narrowing the focus of surveillance; the conduct of regional surveillance; surveillance of the industrial countries and the euro area; shifting the responsibility for WEO projections to the Research Department (RES); the review process; the role of the Board; and transparency and Fund surveillance. A first annex provides extensive comments from RES on the WEO and the ICMR and the Department’s analysis of capital flows; the staff in general associates itself with these comments. A second annex provides more factual and detailed comments from individual departments on a variety of other points.
7. This note does not comment on the interesting observations of the report on standards and the Contingent Credit Line: discussions on these issues continue at the level of the staff, management, and the Board; policy and practice are undergoing rapid change, and thus the report’s observations, and staff responses, would almost certainly soon be out of date.
8. In general, the view of the staff is that the report of the evaluators provides an informed outside perspective that should serve as an important input to the Fund’s deliberations on further strengthening surveillance.
The Focus of Surveillance
9. There has been much debate, including in the public domain, over the broadening of the surveillance agenda in recent years. The call for increased focus in the Fund’s surveillance is not new and remains a challenge for the organization in light of the forces driving an expanding agenda. In its review of lessons from the Asian crisis for Fund surveillance, Executive Directors underlined that the focus of surveillance needed to extend beyond the core short-term macroeconomic issues, while remaining appropriately selective.1 In this regard—bringing an appropriate focus to surveillance—there are important areas of agreement between the report and the proposals to bring more focus to surveillance presented in the 1998 staff paper “Lessons for Surveillance from the Asian Crisis” and agreed by the Executive Board:
- Surveillance should pay more explicit attention to capital account/financial sector/contagion issues and external vulnerability.
- Surveillance at the country level should pay greater attention to policy interdependence and the risks of contagion.
10. Notwithstanding the identification by the Fund’s internal reviews of the need for more attention to these issues in Fund surveillance, we agree that implementation of these general principles has taken time. This can be explained, in part, by limited resources and, in some areas, expertise.
11. The staff find the demands arising from the sheer scope of surveillance issues to be challenging, particularly in areas necessitating new expertise. We are also well aware that the broadening focus of Fund surveillance has significant resource costs. However, the staff recognize the analytical necessity of the broadening of surveillance to cover certain areas if surveillance is to continue to be relevant. In this regard, the staff doubt very much that the Fund could be more effective by focusing on core macroeconomic and financial issues to the exclusion of structural issues. Selectivity, yes, but to focus only on macroeconomic and financial issues misreads the needs and demands of the Fund’s membership.
12. As the report correctly points out, there is substantial pressure from the international community and shareholders to bring additional dimensions to the surveillance process. Following the Mexican crisis of late 1994-95, there were calls by the international community for more intensive treatment of members’ financial sectors in Fund surveillance. In the immediate aftermath of the Asian crisis, the significance of transparency, data dissemination, financial sector stability and hence standards, and the need to extend beyond the core short-term macroeconomic issues have received increasing emphasis. While the report acknowledges the forces that have driven the broadening definition of “core issues” in Fund surveillance, it does not examine these forces squarely in coming to its recommendations on the focus of surveillance. A recent Board discussion on Mexico is illustrative in this connection for its heavy emphasis on progress in social policies over recent years, as is the June 1999 G-7 Communique calling on the Fund to pay greater attention to social sector issues.
13. Staff particularly emphasize the following points on the focus of surveillance:
- The report takes exception to the Fund’s involvement in a number of areas that are considered to be outside the Fund’s statutory mandate, including trade liberalization, labor markets, offshore banking supervision, tax reform, expenditure streamlining, military outlays, and income distribution. While staff would agree that the Fund should remain primarily a macroeconomic institution, the Fund’s Articles of Agreement and decisions of the Executive Board2 suggest a far broader mandate than the authors seem to have in mind.
- We believe that another key reason for the expanding scope of surveillance beyond traditional macroeconomic analysis is the realization by policymakers, international organizations, and the economics profession as a whole that there is a wider set of issues (microeconomic or structural in nature) that must be considered when analyzing the international monetary system, stabilization, medium-term sustainability, and growth—all key areas of Fund surveillance. Even if greater focus is achieved, a good macroeconomic analysis needs to view the macroeconomy in the broader context of the structural, social, political, and environmental setting. To be relevant in Western Europe, for example, Fund surveillance must be able to address labor market issues; in Central and Eastern Europe, privatization and enterprise restructuring; in Africa, civil service reform; and so on. Of course, the staff accepts that its attention to those areas should draw on the best work available outside the Fund.
- Relatedly, the Fund has come to learn the hard way that, over the longer run, the sustainability and viability of reform policies depend critically upon the large number of factors that affect growth. These include, among other things, governance, the composition of expenditures, and poverty. Many of these may not fall in the class of issues that the report would consider “directly relevant” to macro policies; yet, as experience shows, they can prove critical over the longer term.
- The Fund’s membership covers a heterogeneous set of countries. What is a core issue may differ across countries. In a number of countries, structural issues outside the macroeconomic and financial areas, characterized by the report as “noncore,”3 are nonetheless at the core of the problem. It would thus be odd if the Fund were to sidestep these issues.
- On the need for greater attention to capital account issues, the staff have been providing analyses of capital flows for many years, although attention intensified following the Mexican crisis and with the increasing integration of capital markets.4 The staff, like others, have a learning curve.
- As the scope of surveillance has broadened, the staff are increasingly drawing on the expertise of other agencies where appropriate and feasible. Examples of this approach include the recent reliance on OECD work in framing certain elements of Fund advice to countries such as Korea and the recent initiatives to strengthen Bank-Fund collaboration in financial and social sector work. As the report acknowledges, in some noncore areas, the Fund has to step in, not so much as the chosen instrument, but rather the only presently available instrument. This issue has also come to the fore in the discussion of transparency reports, where some working knowledge on the part of Fund staff in noncore areas has been found desirable.
- The recommendation to focus on the “core” of surveillance, as the authors see it, leaves unanswered how this would affect the content of Fund-supported financial programs. If Fund staff did not have the opportunity to build their intellectual capital in “noncore” areas in the context of surveillance, would they still be expected to develop and apply conditionality relating to such issues in subsequent Fund-supported programs? How would “noncore” work currently carried out by the Fund be shared with other institutions?
14. For the reasons indicated above, and although we are in agreement on the appropriateness of containing the scope of Fund surveillance, it is not easy to see how a return to the traditional core areas could be accomplished in the current international context. Most staff believe that if surveillance is to continue to be relevant, its scope will need to change in response to the evolution in the world environment. What may be required is to sharpen the focus of surveillance in the individual case (avoiding a “shopping list” approach), allowing sufficient flexibility to mission chiefs to determine what are the core issues in each country within the Fund’s broad and evolving interests. However, there are trade-offs in all of these approaches that might usefully be noted: a narrow focus on the “core” risks missing important issues; a “shopping list” approach is a recipe for superficiality; and a country-by-country approach to focus raises issues of consistency of treatment across countries. In light of the above, the staff see the need for further examination of these trade-offs in the Fund’s surveillance activities, including in internal reviews.
The Fund’s Conduct of Regional Surveillance
15. The Fund’s approach to regional surveillance emerges as an important theme, and staff agree that regional surveillance should receive greater emphasis. In this regard, the Fund has increased its involvement in regional surveillance in recent years, in part linked to initiatives among member countries themselves, and some additional aspects of this involvement are worth noting.
16. The Fund has devoted increasing attention to systematic participation in regional surveillance processes and to the development of these processes, not only in the euro area, but also in Asia, Africa, Latin America and the Caribbean, and the Middle East. In this regard, the report seems overly focused on Europe as a model for regional surveillance. As the report notes, the fact that other regions—such as Asia—are not as integrated as Europe, and will most likely remain so, suggests a different role—one being explored by the Fund—for regional surveillance as follows:
- Regional surveillance in Asia is implemented through a range of channels. The Managing Director participates in, and the staff prepare background information for, meetings of ASEAN Finance Ministers. The Fund has been designated as the technical secretariat of the Manila Framework Group that was established specifically to undertake macroeconomic surveillance. The staff also work with various arms of ASEAN and other regional groups. The establishment of the IMF’s Tokyo office was an explicit recognition of the growing role of Asia, and working with various regional groups as part of surveillance is one of its major tasks.
- In the African region, the Fund has established periodic discussions with WAEMU, the BCEAO, and BEAC as a backdrop for bilateral consultation discussions with relevant members. Through the vehicle of cross-country initiatives, the Fund is playing an active role in assisting regional organizations in Eastern and Southern Africa to develop their capacity and policy focus in a harmonized way.
- Spillover effects of last year’s crisis in Russia have been a focal point of most missions to transition economies in Central and Eastern Europe and the Commonwealth of Independent States (CIS) recently.
- The Fund has increased its involvement with the countries of the Gulf Cooperation Council (GCC) in the context of a regional framework. Recently, in the wake of the decline in oil prices, a framework of semiannual consultations with the GCC countries at the regional level has been established.
- Beyond the reference to the Fund’s lead in September 1998 in convening Western Hemisphere finance ministers and central bank governors to discuss common issues, including contagion effects of the crises in emerging markets, staff have been exploring with member countries in Latin America ways of enhancing regional collaboration.
- Finally, surveillance of the Organization of Eastern Caribbean States in the Caribbean region includes a role for the Eastern Caribbean Central Bank—the regional monetary authority—again, as the backdrop for bilateral discussions with members.
17. The Fund’s engagement in many of these areas is relatively new and to a degree experimental, and is increasingly seen as a means of coping with evolving regional arrangements. Staff agree that more needs to be done and that country surveillance should emphasize regional and spillover issues and bring to bear more of a cross-country perspective.
Surveillance of Industrial Countries and the Euro Area
18. The report proposes to reduce surveillance of smaller industrial countries, to shift euro area surveillance to the EU, and to focus more on the international implications of the largest industrial countries’ domestic policies and correspondingly less on advice regarding domestic policies per se. While staff can see the merit of some reallocation of resources away from industrial countries generally, we have reservations about the implications of moving too far in this direction for the effectiveness of surveillance.
19. The introduction of a two-tier surveillance structure in which smaller industrial countries would be visited less frequently raises questions about the effectiveness of surveillance:
- The main effect of the shift to a two-year consultation cycle would be to reduce the Board’s involvement—which runs against the evaluators’ proposals elsewhere in the report to increase that involvement. At present, countries on two-year cycles often have interim discussions that resemble Article IV discussions, except with regard to the documentation prepared for the Board.
- Implementation of the recommendation that surveillance of individual participants in the euro area should largely take place at the euro area level and through EU institutions would, at this stage, detract from the quality of the Fund’s surveillance of individual participants in the euro area. Indeed, the recommendation sits oddly with the report’s earlier acknowledgment of the relative candor of bilateral discussions and the reluctance of countries to engage in frank exchange and criticism in regional forums. The proposal is also not consistent with members’ obligations to collaborate with the Fund in the context of bilateral Article IV consultations, and would largely remove Fund surveillance from the effective levers of policy. Talking about the euro area’s fiscal policy would be to no avail in the absence of discussions about policies in individual countries.
- Similarly, we question the prudence of moving small and medium-sized industrial countries to two-year consultation cycles, as the proposal seems to assume that these countries will not have a crisis, or, if they do, they can take care of themselves. This proposal seems at odds with the report’s emphasis on strengthening the role of surveillance in identifying vulnerabilities and risks of financial crises. If the Fund had adopted this recommendation earlier, it certainly would have put into this group some countries that have faced serious crises in the past decade. The experience of the Asian crisis is a reminder that today’s star economic performers can become tomorrow’s crisis countries.
- The fact that standard surveillance has not produced adequate warnings might be seen as an argument for strengthening, not weakening, consultation procedures. Published data and analyses complement (and provide important input for) the direct policy dialogue, but they are not a substitute. As the experience in some cases has shown, these sources can sometimes be quite misleading.
20. Staff are also skeptical about the scope for and desirability of cutting back resources for industrial countries, the room for savings in this area, and the suggestion that the focus of surveillance for the largest countries be mainly on the international implications of their policies.
- In the staff’s view, the evaluators are unduly pessimistic with regard to the usefulness of the Fund’s surveillance of industrial countries. The Fund’s value added lies importantly in providing a disinterested outsider’s analysis of national issues from a global perspective. Neither financial markets, the press, nor academic researchers provide this type of information, at least not on a regular basis. Examples include the analyses of German unification and the recent issues facing Japan.
- A policy of less frequent surveillance of industrial countries would need the endorsement of their authorities. Only a few such countries have made use of the voluntary option of a two-year consultation cycle, in the context of “selectivity” endorsed by the Board in April 1997 and made operational at the end of that year.
- The idea that the objectives of surveillance vary by type/size of country is contrary to the Fund’s role as a global institution, and to the principle of uniformity of treatment that is essential to the Fund’s relations with its members.
- It is not accurate that industrial countries never get into trouble and therefore have little to gain from “full” surveillance. The example of Japan is an obvious one, as are the periodic exchange rate crises in Europe in the last decade. We also believe that surveillance has helped intensify fiscal consolidation efforts in a number of countries, including Belgium, Italy, and Sweden.
- The evaluators recommend that fewer resources be devoted to industrial countries, but that the WEO be published more frequently; yet the latter would depend critically on more regular examination of developments in industrial countries.
Shifting the Responsibility for WEO Projections to RES and Publication of Quarterly WEO Forecasts
22. The report proposes to shift the ultimate responsibility for WEO projections to RES. Staff are concerned that the report downplays the complementarities that exist between bilateral and multilateral surveillance that would be weakened by such a shift. Staff also view bilateral surveillance as the bedrock of the Fund’s work and the basis for multilateral surveillance. While we share some of the concerns of the evaluators about the ownership of the WEO forecasts, the report appears to have underplayed aspects of the Fund’s internal processes—including informal as well as formal mechanisms to air and resolve differences of view in this area. However, while most departments feel that the interdepartmental mechanisms for coordinating the projections generally work well, the Research Department view is that in selected instances where significant differences between the staff of the Research and area departments have emerged, the process of resolving these differences has not worked as well as it should have.
23. The following specific issues were raised on this topic:
- Staff are concerned that if RES were to have final responsibility for projections, it would imply that the country desks would have no ownership of the IMF projections for their countries. Most staff see this as unworkable.
- To allow different country forecasts to be used in WEO, on the one hand, and in bilateral surveillance and program work, on the other, would be confusing to the public and would limit the scope for country-specific knowledge to be incorporated into the WEO forecasts.
- Staff acknowledge, however, that the current ownership of projections needs to be clarified, as some departments view projections as forecasts of the area departments only, whereas other departments see them as forecasts of the entire organization—a situation that at times has led to conflicting presentations to the public.
- RES shares the concern of other departments that a full shift of responsibility would pose significant operational and other difficulties, including less careful preparation of forecasts by area departments if they no longer have the final responsibility; and the large resource implications of the proposal. However, RES also feels that there have been serious problems that have occasionally arisen with the WEO forecasts that deserve the attention of management and the Executive Board.
- On interdepartmental interactions, there is already much more consultation with RES than suggested by the report. The extent to which the Fund’s policy assessment of the situation of the major industrial and developing countries is developed collectively, with input from functional as well as area departments, is underplayed.
- Most staff see a degree of tension in interdepartmental relations as an inevitable and healthy part of the multilateral surveillance process. While there may have been problems on occasion in the past, affecting capital markets work as well as the WEO, these are overstated in the report, and have not gone as far as a breakdown in communications. Moreover, where difficulties have occurred, considerable efforts have been made to ensure closer coordination between departments.
- Staff note the inevitable tension also between global assessments and forecasts underlying Fund programs, given the difficulty in assuming that Fund programs might fail, even though some inevitably will. Shifting the responsibility for forecasts will not resolve these tensions, which could be better dealt with through alternative scenarios analyzing downside risks.
- Staff of RES feel that the evaluators have missed some important points about how information about the Fund’s forecasts is conveyed to the Executive Board. When there are significant differences between the Research Department and the area departments over the WEO forecasts, the Executive Board is usually informed of these differences, at least in qualitative terms, in the course of the WEO or World Economic and Market Development (WEMD) sessions.
- Finally, staff do not support a shift to quarterly WEO forecasts. Such a shift would imply a substantial increase in the staff’s workload, potentially compromising the analytical content of these reports (which is a critical aspect of their comparative advantage). We also consider it important to retain some independence between the WEO and ICMR, and, when warranted by circumstances, ad hoc WEO/ICMR exercises could be produced to ensure that coverage of world developments is appropriately current (as was done in the early 1980s and also last year).5
24. The evaluators provide some interesting observations on the review process. Staff recognize that the review process is resource-intensive, and that constant effort is required to manage it effectively. However, staff see this process of internal criticism and peer review as playing a critical role in enhancing the surveillance effort and improving the final product. Thus, most staff would like to see efforts first focused on addressing specific problems that have been identified and ensuring that the process is taken seriously, rather than unduly curtailing the resources devoted to internal review. On this issue, staff emphasized the following points.
- Most staff (including both functional and area departments) are not in favor of more informality in the review process. There is already a great deal of informal give and take that is undocumented. More generally, in our view, moving away from written to oral feedback might serve to lessen responsibility, impair institutional memory, and make for less-considered comments.
- While replacing formal comments with emails and phone calls may streamline the review process, it is important that all departments remain aware of each other’s comments.
- Replacing formal comments with meetings would likely only increase the burden on reviewing documents: staff from reviewing departments would still need to write comments to brief those participating in the meetings.6 Also, from the recipient perspective, meetings are often much more time-consuming than written comments.
- Other reactions were also registered by staff, including that some of the criticisms of the review process are already being addressed by management guidelines; that cutting review resources would have to be balanced against the benefits of the process (such as better checks and balances and better integration of technical assistance activities with surveillance); and that effective solutions would require delving more deeply into the role of reviewing departments. This is an area to be pursued.
Role of the Executive Board and Proposals for Restructuring
25. Staff read with interest the proposed changes in the role of the Executive Board through the introduction of a two-step briefing process and of a committee structure. Although it was clearly understood by all that the Executive Board decides how to structure its work, in our view there are key aspects of the Fund’s internal processes—and channels of interaction—that cumulatively and collectively raise issues to the Executive Directors in a timely fashion. We believe that there are important countervailing arguments, particularly concerning the resource implications of the report’s proposals. The following specific comments elaborate on the general thrust of staff views.
- Effective procedures already exist for the Executive Board to express its views and provide guidance, for example through the regular consultation cycles and use of Fund resources meetings (whose policy conclusions are regularly referred to and followed up in subsequent Article IV discussions), country matters sessions, and WEO, ICMR, and WEMD sessions.
- The two-step briefing process potentially creates significant additional work both for the Executive Board and for the staff, especially if considered in conjunction with the proposals to implement quarterly WEO/ICMRs and more frequent and continuous surveillance.
- Resource savings, if any, from the committee approach would most probably come at the expense of the smaller countries, which would be the ones most likely to be discussed solely at the committee level, creating a “dual track” of surveillance that would undermine the global nature of the present system and tend to introduce bias against small states.
- The new regionally based committee structure might involve increased resource costs given the need for greater coordination between the Board, committees, and the staff. In addition, it is not unlikely that many countries would be discussed by the full Board.
- The new structure could tend to undermine the process whereby information is transmitted through Executive Directors to their capitals, and would require difficult and time-consuming balancing so that participation by Directors on committees was appropriately representative.
- Despite the safeguards proposed by the evaluators, pressures toward “clientism” and a “regional perspective” could only increase relative to the present system, amplifying and interacting with the preexisting biases that the evaluators identity as operating at the area department.
Transparency and Fund Surveillance
26. On a final note, while supporting publication in general, we are somewhat less sanguine about the suggestion that “publication of staff reports should provide important support over time for greater frankness.” The evaluators observe an opposite result in OECD reports and the danger that policy differences could be smoothed over in the final report is something that would need to be guarded against. While there are strong advantages to transparency and accountability in publishing, it is not enough simply to assume away the problem that publishing may reduce some country authorities’ willingness to speak candidly about policies. In fact, the pilot project for the release of Article IV staff reports is intended to try to address this and other issues of concern to Directors, and the staff would not want to prejudge the outcome of this experiment.
27. Relatedly, staff are unpersuaded by the view that, because Article IV reports already circulate to some degree outside the circle of authorized users (a tendency that some thought the report exaggerated), they should be available to everyone. It is true that the general publication of Article IV reports might help to create a level playing field for all users; unauthorized leaks, even if widespread, allow unfair access to those benefiting from the leaks. However, the report’s proposal—that the Fund publish the staff report for each Article IV consultation whether or not the relevant member consents—raises several legal issues, as the report acknowledges, that are not so easily tackled. First, the Fund may not publish a staff report disclosing confidential information without the member’s consent. Second, even where confidential information would not be disclosed, the Fund’s Articles permit the Fund to publish its views (e.g., on a member’s policies) without the relevant member’s consent only if they deal with “monetary or economic conditions and developments which directly tend to produce a serious disequilibrium in the international balance of payments of members.” Finally, a special majority of the Fund’s Executive Board (i.e., 70 percent of the Board’s total voting power) must vote for publication of such reports.
Annex I Excerpts from Comments from the Research Department
The Role of the Research Department
The evaluators clearly express a generally favorable assessment of the Research Department’s contributions to Fund surveillance, especially to multilateral surveillance, where RES has the lead responsibility. Of course, we appreciate this favorable evaluation. Nevertheless, we have two specific concerns about what the evaluators recommend and say in their report.
The WEO and ICMR
First, while we appreciate the implicit compliment in the recommendation for quarterly publication of a combined WEO/International Capital Markets report, we have grave reservations about this suggestion. An essential element of the value added of the ICMR is that it brings a “capital markets perspective” to important multilateral surveillance issues, meaning that its focus is on the role of financial market participants, institutions, and regulations. For example, the analysis of the ERM (exchange rate mechanism) crisis provided in Part I of the 1993 ICMR provides such a perspective on the factors involved in the ERM crisis—a perspective different from the macroeconomic perspective on the crisis that is presented in the WEO, focusing on the role of macroeconomic developments and policies. Neither perspective contains the whole truth; both are relevant and valuable. Similarly the ICMR perspective on the Asian/Russian/Long-Term Capital Management crises is different from, and adds considerable value to, the WEO perspective on these crises.
Especially in an institution that places heavy emphasis (some would say, excessively heavy emphasis) on macroeconomic analysis, combining the WEO and the ICMR on a regular basis would, we believe, tend to undermine the analytical independence of the ICMR and would, over time, undermine its unique value added. Moreover, an essential element in the preparation of the ICMR is the system of staff missions to key financial centers and to a variety of emerging market countries to gather information, analysis, and opinions (especially from private market participants) on the issues to be covered in the report. It would be very difficult and disruptive to attempt to make this system of missions conform to a quarterly schedule of publication, while still leaving time for the missions to be planned and executed and for the report to be thought out, written, reviewed, considered by the Executive Board, and published.
These concerns do not preclude the possibility of semiannual updates of the ICMR, perhaps sometimes combined with interim updates of the WEO. Last December’s combined WEO/ICMR is a useful example of how this can be done, in consultation with the Executive Board, when developments in the world economy and global financial markets appear to warrant it. But the genesis of such reports would be best determined on an ad hoc basis. Beyond this, the plan is to expand gradually the analytical content of the quarterly private financing notes that are now distributed to the Executive Board (but not published) and to take up discussion of issues raised in these notes, as may be needed, in the WEMD sessions. This, of course, will not satisfy demands from outside the Fund for more frequent updates on international capital market developments and issues, but those folks are not paying the bills for the exercise.
Regarding the frequency and schedule for the WEO, it must be recognized that the WEO plays a central role in providing material for meetings of the Interim Committee and, correspondingly, the present semiannual schedule for the WEO reflects the schedule of meetings of the Interim Committee. Typically, there are nearly seven months between the late- September/early-October and the late-April meetings of the Interim Committee and, correspondingly, there are barely five months between the late-April and the late-September/early-October meetings. Given the usual schedule for preparation of the WEO, it is essentially inconceivable to think of an interim WEO during the summer. Even allowing for some compression of the normal WEO schedule (as suggested by the evaluators), an interim WEO presented to the Executive Board in late July or early August, followed by a full WEO presented in early September, makes no sense. (As far as the Executive Board is concerned, the WEMD sessions can be used, and have been used, to fill in the gaps.) The fact is that the primary value added by the WEO, relative to information and forecasts produced in the private sector, is not rapid revisions in assessments of the outlook, but rather timely and relevant analysis of the economic forces shaping the outlook and of the risks to the global economy. Too high a frequency would destroy its fundamental value.
When something of global economic significance happens in the late summer or early autumn, it is feasible to produce an interim WEO in December or early January. This was demonstrated in the cases of the ERM crisis, which broke in mid-September 1992, as well as in the Asian and Russian/LTCM crises of 1997 and 1998. It would be possible to plan for a regular edition of an interim WEO or interim WEO/ICMR at every year-end. However, with pressures on staff resources already beyond the sustainable level, and with the need to plan, and think, and research to sustain the quality of both the WEO and the ICMR, we believe that it is better to address the issue of a year-end WEO/ICMR on an ad hoc, as-needed basis. Experience with this procedure, we believe, demonstrates responsible and constructive decision making.
Analysis of Capital Flows
Second, RES has important concerns about Box 3.2, in which the evaluators assess how the WEO and the ICMR dealt with the issues of capital flows and financial crises. This is clearly one area where published information provides evidence and substance to support an evaluation of the effectiveness of the Fund’s work but where too little attention has been paid to the evidence contained in the Fund’s reports. While we accept a number of the conclusions in this box as reasonable, or at least arguably plausible, we strongly believe that the evaluators go too far in three specific statements that are effectively contradicted by a fair reading of what was actually said in the WEO and by other information provided to the Executive Board (which has responsibility for the conduct of surveillance). The following statements, we believe, need to be reconsidered and significantly modified in light of the facts.
… when doubts about the sustainability of capital flows were voiced—more frequently in the ICMR than in the WEO—they did not put much emphasis on weakening financial systems in the capital-importing countries. . . . [emphasis added]
… the importance of potential regional and international contagion of currency crises was given very little attention prior to the crisis, even in internal analyses. [emphasis added]
The overall impression of Fund multilateral surveillance as expressed through the WEO and the ICMR is that while these documents did make a number of pertinent observations on capital flows and financial crises that are helpful in understanding subsequent developments in Asia and elsewhere, the risks were not forcefully presented. [emphasis added]
The footnote attached to this last statement adds the following:
In our interviews, staff suggested that such warnings were in fact present and indeed couched in language that was quite strong, in Fund terms. However, one well-informed and disinterested observer was of the view that the basic drafting strategy was to say as little about risks as possible, while at the same time still being able to claim, if the risks did become reality, that they had been addressed. [emphasis added]
The exposition of why we believe that these statements are not well supported and merit reconsideration and revision is detailed and extensive. We go into it not only because of its importance to the evaluators’ assessment of the multilateral surveillance work of RES, which is overall quite favorable, but also because of the deficiencies that it suggests in the methodology that the evaluators have employed in reaching their broader conclusions and recommendations. The evaluators have relied, to a great extent, on the information gathered from their extensive interviews with a wide array of individuals who are knowledgeable, to a greater or lesser extent, about the Fund’s work on surveillance and its effectiveness. In contrast, the evaluators appear to have spent much less time and energy on their own direct examination and evaluation of the Fund’s surveillance work.
The evaluators’ approach is surely efficient and, in many respects, the right approach. It is important for the evaluators not to base their judgments too heavily on their own assessment and prejudices, but rather to seek much wider views among people well informed about the Fund’s surveillance activities. However, outside observers also have their prejudices, and it is important to countervail them with careful scrutiny of the documentary evidence. For much of the Fund’s surveillance work, the documentary evidence—records of discussions with authorities, Article IV reports, minutes of Executive Board meetings, and so forth—is not publicly available. For the WEO and the ICMR, in contrast, the published versions are available. This makes it possible to compare the judgments and conclusions reached by the evaluators on this component of the Fund’s surveillance work, based on their own judgments and the opinions gathered from informed outside observers, with the record of what was actually said in the WEO and the ICMR. Faced with the evidence, readers may be left to judge whether the conclusions of the evaluators are well-founded with respect to this specific area of Fund surveillance, and they may be allowed to make broader inferences about the basis for the evaluators’ conclusions in other areas where the documentary record of the Fund’s surveillance activities is not publicly available.
The fact is that on page 2 of the May 1997 WEO there is a quite explicit warning that two among the four key risks to global growth are those arising from disruptions in capital flows to emerging market economies, including the possibility of contagion, and from fragilities in their banking systems.
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, the fragile banking systems are of concern in a broad spectrum of countries. These problems often stem from excessive credit expansions 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.
A similar warning is reiterated in the October 1997 WEO (p. 2), before the attack on the Hong Kong dollar signaled the general onset of the Asia crisis. On this occasion, the risk to the sustainability of capital flows to emerging markets, the possibility of contagion, and the problems of weaknesses in financial systems are all linked together as one of the three key risks to global growth.
Sustainability of capital flows to emerging market countries. Several factors have contributed to record capital inflows into many emerging market countries and an associated compression of yield differentials in recent years, including the trend toward a more open global financial system and the increasingly successful economic policies pursued in many recipient countries. But the availability of these flows and their costs are also influenced by global cyclical conditions and are vulnerable to higher interest rates in world financial markets as well as to perceptions that large current account deficits—the counterpart to capital inflows—may not be sustainable in all cases. The crisis in Mexico late in 1994 and more recently the financial pressures that have affected Thailand and a number of countries in Southeast Asia underscore the importance of disciplined macroeconomic policies and robust financial sectors. They also have highlighted the risk and costs of potentially disruptive changes in market sentiment, including the danger of very strong reactions in financial markets and serious spillovers to other countries when critical policy weaknesses are not addressed in a timely manner.
The rest of this chapter summarizes the IMF staff’s near-term projections and policy assessments and identifies some key policy concerns that need to be addressed in order to strengthen medium-term economic prospects in all countries in accordance with the guidelines set out by the Interim Committee in its September 1996 “Declaration on Partnership for Sustainable Global Growth.”1 Other issues discussed include the prospects for EMU and its potential longer-term implications for Europe, lessons from recent exchange market crises and the trend toward greater flexibility of exchange rate regimes in developing countries, the challenges facing monetary policy in the transition countries in safeguarding progress toward macroeconomic stability, and the need for so-called second-generation reforms to sustain high-quality growth in all regions.
To provide the context and to show the prominence given to these warnings, the first three pages of the May and October 1997 WEOs are attached. Also attached are the relevant initial pages from the October 1996 WEO, which contain no similar warning. It is apparent that the warning clearly issued in the May 1997 WEO and reiterated in the October 1997 WEO was not just “boilerplate” that is commonly included in the WEO to protect against later accusations that some important risks, subsequently actually realized, were overlooked. The prominence and the clarity of the warnings in the May and October 1997 WEOs were upgraded over those in earlier WEOs in order to indicate rising levels of concern about a possibly imminent problem. Of course, not everyone reads the WEO in the same way. Some will not understand or appreciate a warning even when it comes in clear language in a prominent location. Perhaps this is especially so for those who have a vested interest, or at least a psychological interest, in believing that they were not adequately warned because they continued to participate in the massive flow of capital to emerging market countries even after the May 1997 WEO warning that such flows might prove unsustainable. Is the unnamed individual quoted in the evaluators’ footnote in this category? We don’t know.
Nevertheless, we do assert that on a dispassionate reading, the May 1997 WEO does provide a clear warning of important risks to global growth from potential slowdowns or reversals of capital flows to emerging markets, possibly magnified by contagion, and from fragilities in their financial systems. If the evaluators disagree, as they clearly do in Box 3.2, then they should continue to assert their conclusions. However, the footnote disparaging the staff response to this box should have been deleted; it cites one anonymous source whose objectivity and motives may be suspect or who is unaware of the facts. Rather, in their report the evaluators should have quoted the entire text of the two relevant paragraphs providing the warning in the May 1997 WEO (and noted the reiteration of this warning in the October 1997 WEO), they should have noted the prominent position of these paragraphs in the WEO, and they should have emphasized the difference between this warning and what was said in earlier WEOs. The reader could then have been left to judge whether the warning provided was reasonable and, correspondingly, whether the judgment of the evaluators is entirely fair.
The above comments relate to publicly available information. However, Box 3.2 also refers to the preparation by the staff in late August 1997 of “a—broadly upbeat—memorandum to the Board on the risks of contagion in Asia [that] did not even mention Korea.” In fact, this reading of the record ignores the fact that, in his presentation to the Executive Board on August 27, 1997, the Economic Counsellor clearly indicated that he saw the risks for a number of countries in Asia as being on the downside and that a realistic downward revision would probably lower the forecasts for some countries by 2-3 percentage points. He recommended against making such an adjustment at the time, in view of the concern that such action could exacerbate the crisis. However, some modest downward revisions were subsequently made to the forecasts for the published WEO, along with the inclusion of a more forceful discussion of the risks as indicated earlier.
Could and should the warning of a possible crisis affecting capital flows to emerging markets have been issued earlier? In the May 1994 WEO, before the “tequila crisis,” a warning was given in the initial discussion of prospects and possible risks for developing countries (Chapter 1, page 7).
… the surges in capital inflows and in stock market prices give cause for some concern about risk of overheating and the possibility of sudden changes in market sentiment. To minimize the risk of speculative bubbles in the emerging stock markets and a reversal of capital inflows, many of these countries will need to monitor developments carefully to avoid the buildup of imbalances; some countries may need to take corrective measures relatively soon. A number of countries may also need to strengthen prudential supervision of their financial systems and, in some cases, broaden and deepen financial market reforms.
This warning was reinforced in a more extensive discussion of equity flows to emerging markets and their risks (in Box 4, pages 26-27). Then, in the October 1994 WEO, the risks from a possible sharp slowdown of capital flows to some emerging markets were again noted (in the initial discussion of prospects and risks for developing countries, on page 6): “In a few cases, the rise in capital flows appears to have reflected the general enthusiasm for emerging financial markets, rather than well-founded confidence in economic prospects. For these countries, the risk of sudden changes in market sentiment is particularly serious.” The main chapter on developing countries was devoted to “The Recent Surge in Capital Flows to Developing Countries,” and provided a balanced assessment of the benefits, problems, and risks arising from such flows. To drive home the potential risks, the chapter concluded with an alternative scenario to the WEO baseline forecast that showed how a “sharp reversal of capital flows,” together with policy slippages, in developing countries could have substantial and sustained adverse effects. The chapter concluded with the warning, “Despite the generally positive character of the large capital inflows, there are a number of countries where the confidence of foreign investors may not be warranted on a sustained basis.”
Granted, these warnings were not quite as prominent as those presented in the May 1997 and October 1997 WEOs. Granted also, these warnings were not a forecast of the Mexican devaluation of December 1994 and of the “tequila crisis” that would follow in its wake. Nevertheless, someone who read the 1994 WEOs in any depth, especially someone who was interested in capital flows to emerging markets and read Box 4 of the May WEO and, especially, Chapter IV of the October WEO, would have recognized that there were significant risks that recent surges of capital flows were not sustainable for at least some emerging market countries.
With the onset of the tequila crisis in late 1994, capital flows to Latin America fell off sharply, with flow reversals experienced by Mexico and Argentina. Interest rate spreads shot up for Latin American borrowers. Other emerging markets generally felt only quite brief adverse spillovers, and net private capital flows to all emerging markets picked up in 1995 over 1994 levels, with substantial gains mainly for Asia. At this time, with an actual crisis affecting several emerging market countries, and with markets sensitized to risks, there seemed to be little point in stressing the possibility of an even deeper and more widespread crisis. Indeed, the perception in the Fund was that financial markets had overreacted to the true underlying weaknesses in Mexico and, especially, Argentina; and the effort of the international community was to help rebuild confidence in order to promote recovery in the countries directly affected and limit risks of a spread of the crisis.
Nevertheless, the October 1995 WEO in Chapter IV, “Increasing Openness of Developing Countries—Opportunities and Risks,” devoted considerable attention to the risks of capital flow reversals and emphasized both weaknesses in domestic banking systems and high volumes of short-term capital inflows as factors likely to aggravate such risks seriously. The message was largely one of important lessons to be learned from the tequila crisis, rather than a clear warning of imminent risks. In the concluding section of the chapter on “Implications of a Reversal of Capital Inflows,” an alternative scenario was again used, as in the October 1994 WEO, to dramatize the adverse consequences of a possible future substantial slowdown of capital flows to emerging markets.
The revival of capital flows to Latin America, the continuing increase in gross private capital flows to emerging markets generally, and the narrowing of spreads in late 1995 and the first half of 1996 (see Figure 1) were generally regarded as welcome and healthy developments. By July 1996, when the October WEO was being prepared, the sharply rising volume of, and declining spreads on, capital flows to emerging market countries were pointed out, with a degree of concern about possible overexuberance, to the Executive Board in the WEMD session. At that time, however, there did not yet appear to be sufficient reason from global financial developments to express a clear warning about imminent risks concerning the sustainability of financial flows to emerging markets. The evaluators disagree but have not made clear the basis for their disagreement (other than hindsight).
Figure I.EMBI Spread and Gross Private Capital Flows
By late 1996 (in the WEMD session of late November) and surely by early 1997 (in the WEMD session of mid-January), concerns about the healthiness and sustainability of capital flows to emerging markets began to rise as volumes of new gross private financing continued to increase, as spreads for emerging market borrowers continued to decline, and as more and more emerging market entities gained relatively favorable access to global financial markets. The Economic Counsellor raised these concerns with the G-7 deputies and with Working Party Three of the OECD in late 1996 and early 1997. Supporting views were expressed, particularly by central bank representatives. Thus, at the time when the May 1997 WEO was being prepared for Executive Board consideration (at end-March), there was a growing official consensus that there were important risks to capital flows to emerging markets. This concern was expressed publicly, and quite deliberately, in the WEO released to the press in late April and formally published in May.
Could and should the warning of a possible crisis have been more explicit? Until it actually happens, there is no way to be certain whether a financial crisis will occur or which countries it may affect. (For example, recent WEOs have continued to warn about the risks from a possible reversal of large gains in industrial country stock markets that has not materialized.) When the WEO was released to the press in April 1997, the Czech koruna was under pressure, but abandonment of the peg and depreciation of the currency did not occur until May. Slovakia also had large current account and budget deficits, and there were fears that its currency would also be pulled down. If so, other Central and Eastern Europe countries might come under pressure, especially if financial markets began to take a more skeptical view of the sustainability of Russia’s public finances (see the May 1998 WEO, pp. 100-101). After reducing the federal funds rate by 75 basis points when the U.S. economy slowed during 1995 (partly due to spillover effects from the Mexican crisis), the Federal Reserve took an initial 25-basis- point step toward tightening in March 1997 on concerns that the U.S. economy might be moving toward overheating. In the spring and summer, financial markets were anticipating possible further tightenings. Although effects from the Asian crisis later helped to deter such moves, a relevant concern in May 1997 was that further Federal Reserve tightenings might, as in past such episodes, put pressure on capital flows to emerging markets, particularly on flows to Latin America. In such an event, Brazil was seen as vulnerable, and problems in Brazil were likely to affect Argentina. In Asia, the Fund had seen problems developing in Thailand at least since the second half of 1996. Malaysia, which also had a large current account deficit financed by buoyant private capital inflows, was also seen as vulnerable. Other Asian emerging market countries, most importantly Korea, were not perceived to be immune; but as the evaluators indicate, the risks for these countries were not rated as particularly great. Thus, the warning in the May 1997 WEO was a general warning of possible financing problems for a number of emerging market countries and of sufficient importance to be a risk to the baseline scenario for global economic growth, including through the phenomenon of contagion. The location of such financing problems, should they develop, was not—and arguably could not be—identified. A financial crisis of the scale and virulence that struck several Asian emerging market economies after the attack on the Hong Kong dollar in mid-October 1997 was not foreseen or warned about in the May 1997 WEO. But a clear warning about risks of global significance arising from disruption of capital flows to emerging markets and related to problems in their financial sectors was issued.
Were the risks potentially arising from weakness in emerging market financial systems given adequate emphasis in the WEO? Here, the evaluators have a more valid point, although overstated. The May and October 1997 WEOs do clearly emphasize that weaknesses in emerging market financial sectors, especially in an environment of potential disruptions of capital flows, were an important risk. The significance of this problem for some individual emerging market countries, however, was not broadly recognized in the Fund (outside of some staff in the Research Department’s capital markets group), and the risks in this area for specific countries were not noted in the WEO. Korea, which is the focus of attention in Box 3.2, and Indonesia stand out in this regard.
What about contagion? In their paper on “The Role of the Fund” written for Executive Board consideration in the aftermath of the tequila crisis, Masson and Mussa emphasized the “monsoonal character” of disruptions of capital flows to emerging markets. In the debt crisis of the 1980s and in the tequila crisis of 1995, several countries concentrated in the same region were affected by the crisis. The caution in the May 1997 WEO that “the global availability of these flows [of capital to emerging market countries] and their costs are vulnerable to higher global interest rates and to adverse developments affecting systemically important capital-importing countries” conveys the notion of risks to global growth that would arise from something more than isolated instances of disruptions of capital flows to individual emerging market economies. The May 1999 WEO was clearly not the first instance in the recent crisis when serious attention was paid to potential regional and international contagion of currency crises. Beyond the warnings given in the May and October 1997 WEOs, the decision to produce the Interim WEO on the Asian Crisis (which was discussed at the annual meetings in Hong Kong in early October and made available immediately after the attack on the Hong Kong dollar in mid-October) was an emphatic recognition that contagion was not merely a potential concern; it was a fact for Asian emerging market economies and a clear risk for others. By late 1997, the financial media were already talking about “the Asian contagion.” The main purpose of the discussion of contagion in May 1999 was not to emphasize risks of contagion that had already occurred on a global scale. It was to analyze the mechanisms through which contagion operated. The ICMR published in October 1998 and the Interim WEO/ICMR of December 1998 provide further detailed information on how contagion operated through global financial markets.
ATTACHMENT I (World Economic Outlook, May 1997, pp. 1-3)
I Global Economic Prospects and Policies
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.
Chart 1.World Industrial Production1
Following a marked slowdown in 1995, the pace of world industrial activity quickened during 1996.
1 Data are for output in manufacturing in 30 advanced and emerging market economies representing 75 percent of world output; three-month centered moving average.
Chart 2.World Indicators1
The global expansion is expected to continue with the growth of world output and trade above trend, while inflation should remain contained in the advanced economies and slow further in the developing countries.
1 Shaded areas indicate IMF staff projections.
2 Volume of goods and services.
3 GDP-weighted average of ten-year (or nearest maturity) government bond yields less inflation rates for the United States, Japan, Germany, France, Italy, United Kingdom, and Canada. Excluding Italy prior to 1972.
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.
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.
ATTACHMENT II (World Economic Outlook, October 1997, pp. 1-3)
I Global Economic Prospects and Policies
With world output expected to expand by some 4 ¼ percent in both 1997 and 1998, the strongest pace in a decade, the global economy is enjoying the fourth episode of relatively rapid growth since the early 1970s (Figure 1). The expansion is underpinned by continued solid growth with low inflation in the United States and the United Kingdom; a strengthening recovery in Canada; a broadening of recovery across continental western Europe, notwithstanding persistent weakness in domestic demand in some of the largest countries; robust growth trends in most of the developing world, particularly in China and much of the rest of Asia even though some countries are likely to experience a setback associated with recent turmoil in financial markets in Southeast Asia; and evidence of an end to the decline in output, and perhaps a beginning of growth, in Russia and in the transition countries as a group. It is worth recalling, however, that each of the three previous episodes of relatively rapid growth was followed by widespread slowdown and even recession in many countries. Taking account of this earlier experience, is there a danger that the present expansion may soon run out of steam and give way to a new global downturn?
Figure 1.World Output and Inflation1
The expansion of world output is expected to continue above trend, while inflation should remain contained.
1 Shaded areas indicate IMF staff projections. Aggregates are computed on the basis of purchasing-power-parity weights unless otherwise indicated.
Although a moderation of world growth is indeed likely to occur at some point, there are reasons to believe that the current expansion can be sustained, possibly into the next decade. First, there are relatively few signs of the tensions and imbalances that have usually presaged significant downturns in the business cycle: global inflation remains subdued and commitments to safeguard progress toward 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 is helping to contain inflation expectations and real interest rates; and exchange rates among the major currencies, taking account of relative cyclical conditions, are generally within ranges that appear to be consistent with medium-term fundamentals. Second, cyclical divergences have remained sizable among the advanced economies, and there are still considerable margins of slack to be taken up in Japan and continental Europe. Stronger growth during the period ahead in these countries should help support global demand and activity as growth slows to a more sustainable pace in those countries that have already reached a mature stage in their expansions, especially the United States, the United Kingdom, and several of the smaller advanced economies. Third, the recovery that is in progress in the transition countries seems likely to continue to strengthen at the same time as the growing number of successful economies in the developing world are also providing both new markets and increased production capacities; these developments are stimulating trade and growth worldwide while helping to dampen price pressures. Taking into account the combination of the strong catch-up potential of the developing and transition countries and the beneficial effects on productivity of technological advances and increasing globalization, the sustainable rate of world output growth may now in fact be somewhat stronger than in the quarter century since the first oil shock. This view is embodied in the IMF staff’s medium-term scenario, which points to a trend growth rate of world GDP of about 4½ percent between 1996 and 2002 compared with an average rate of expansion of 3¾ percent since 1970.
This generally positive assessment of the global outlook should not lead to complacency because there is a wide range of risks and fragilities that confront individual countries and may affect regional and world economic and financial conditions. The main areas of concern relating to prospects over the short to medium term include the following:
- Risks of overheating. Although world inflation has subsided to the lowest rates seen since the early 1960s, inflationary pressures could reemerge, especially in countries that have reached high levels of resource use. Effective policy to prevent inflation rising requires vigilance not only against overheating in product and labor markets but also in asset markets, and it requires preemptive action when warning signs appear. Problems stemming from large swings in asset prices emerged in the late 1980s and the early 1990s in a number of countries, most notably in Japan but also in Australia, Sweden, the United Kingdom, and the United States, with repercussions on the soundness of financial systems in some cases. More recently, several emerging market countries, especially in Southeast Asia, have experienced similar difficulties in their real estate sectors. Despite some correction in August, there is also reason for concern about the strength of world stock prices, which may to some extent be based on unrealistic expectations about prospects for future profit growth and low interest rates. A more substantial correction in stock prices, were it to occur, could adversely affect confidence and economic activity.
- Uncertainties about the Economic and Monetary Union (EMU) in Europe. The marked convergence of interest rates among the prospective members of the monetary union seems to suggest that financial markets expect the project to go ahead in accordance with the agreed timetable, which calls for the new currency, the euro, to be in place by January 1999. Investor sentiment may still change, however, i f the feasibility of the timetable was perceived to be threatened. In that case, interest risk premiums might again widen for some countries, while the currencies of others might be subject to unwelcome upward pressure. Also, should growth prove insufficient to permit progress in reducing record levels of unemployment in much of Europe, confidence would remain weak; in some cases there might be a risk of resort to counterproductive fiscal policies incompatible with the requirements of EMU.
- Sustainability of capital flows to emerging market countries. Several factors have contributed to record capital inflows into many emerging market countries and an associated compression of yield differentials in recent years, including the trend toward a more open global financial system and the increasingly successful economic policies pursued in many recipient countries. But the availability of these flows and their costs are also influenced by global cyclical conditions and are vulnerable to higher interest rates in world financial markets as well as to perceptions that large current account deficits—the counterpart to capital inflows—may not be sustainable in all cases. The crisis in Mexico late in 1994 and more recently the financial pressures that have affected Thailand and a number of countries in Southeast Asia underscore the importance of disciplined macroeconomic policies and robust financial sectors. They also have highlighted the risk and costs of potentially disruptive changes in market sentiment, including the danger of very strong reactions in financial markets and serious spillovers to other countries when critical policy weaknesses are not addressed in a timely manner.
The rest of this chapter summarizes the IMF staff’s near-term projections and policy assessments and identifies some key policy concerns that need to be addressed in order to strengthen medium-term economic prospects in all countries in accordance with the guidelines set out by the Interim Committee in its September 1996 “Declaration on Partnership for Sustainable Global Growth.”1 Other issues discussed include the prospects for E M U and its potential longer-term implications for Europe and the world economy, the critical need for labor market reforms in Europe, lessons from recent exchange market crises and the trend toward greater flexibility of exchange rate regimes in developing countries, the challenges facing monetary policy in the transition countries in safeguarding progress toward macroeconomic stability, and the need for so-called second-generation reforms to sustain high quality growth in all regions.
The high degree of price stability remains an impressive achievement shared by almost all of the advanced economies. In 1996, the rate of consumer price inflation averaged 2½ percent, and only four countries experienced inflation above 5 percent; measured by GDP deflators, a broader measure of the price level, average inflation was just 2 percent. In terms of output and employment, the picture is much more mixed as underscored by sharp divergences in labor market performance in recent years. Whereas a number of economies including the United States, the United Kingdom, and several of the smaller advanced economies are operating at relatively high levels of resource use, the three major continental European countries have suffered protracted economic weakness that has been accompanied by a dramatic rise in unemployment to postwar record levels. Conditions for recovery have gradually improved, but few forecasters expect the upswing to make more than a modest dent in unemployment. In Japan, the recovery has also proven quite hesitant, as discussed below and in Chapter II in greater detail.
The unsatisfactory economic performance of the three major economies of Germany, France, and Italy cannot be blamed on the external environment. In fact, external markets have been expanding strongly and exports have been the main source of stimulus in recent years. Thus, between 1992 and 1997, the real foreign balance is estimated to have improved by 1¼ percent of GDP in Germany (most of this occurring in 1996 and 1997), 3½ percent of GDP in France, and 5½ percent of GDP in Italy. This clearly indicates that the sources of weakness have been internal, and in fact domestic demand has expanded by less than 1 percent a year in these three countries combined over the past five years.
There are at least four sets of factors that need to be considered in explaining this exceptional sluggishness.
(1) Fiscal consolidation. Since 1992, there has been a substantial effort in many countries to reduce fiscal imbalances that had reached unsustainable levels; although beneficial for growth in the longer run, those efforts have tended to weaken aggregate demand in the short run notwithstanding offsetting effects from lower interest rates and exchange rates. In continental Europe as a whole, however, fiscal policy (measured by changes in cyclically adjusted balances) has not been substantially tighter than in the United States or the United Kingdom. Differences in fiscal stance therefore clearly cannot by themselves explain the differences in growth performance.
(2) Labor market rigidities. The lack of flexibility of continental European labor markets has undoubtedly exacerbated the weakness of economic activity at the same time as product market rigidities may have impeded the private sector’s adjustment to the withdrawal of fiscal stimulus. Some labor market measures, such as work sharing and early retirement, which were intended to reduce open unemployment, may actually have served to dampen growth by reducing the supply of skilled labor and increasing tax burdens and labor costs.
(3) Confidence factors. Although such influences are difficult to assess in isolation from other forces, delays in addressing the root causes of structural unemployment and fiscal imbalances may well have affected business confidence, while labor shedding in response to high labor costs has increased job insecurity and undermined consumer confidence. Excessive reliance on revenue increases to reduce fiscal deficits rather than reform-based reductions in expenditures may also have discouraged both investment and consumption. Recurrent uncertainties about the feasibility of the timetable for E M U have probably added to hesitation in business investment.
(4) Monetary policy. The progressive easing of monetary conditions in Germany and the rest of Europe during 1993 and early 1994, and generally declining risk premiums in long-term interest rates, played a significant role in the first phase of recovery in 1994. As this initial pickup failed to turn into a self-sustained expansion, owing in part to the effects of an overly strong deutsche mark in early 1995, official interest rates were reduced further during 1995 and early 1996. However, while the stance of monetary policy since the latter part of 1993 has supported demand, a somewhat faster and ultimately more pronounced easing of monetary conditions would have helped put the recovery on a stronger footing without jeopardizing price performance. The timing of such easing was constrained by the rise in long-term interest rates in 1994, but an easier monetary stance was justified subsequently by the absence of inflationary pressures, the prevalence of significant cyclical unemployment, the large withdrawals of fiscal stimulus, and depressed levels of consumer and business confidence. As of August 1997, with the further weakening of the currencies participating in the European exchange rate mechanism (ERM) vis-à-vis the U.S. dollar and the pound sterling providing additional stimulus, monetary conditions in continental Europe appear to be sufficiently supportive of the emerging recoveries.
Movements of major currency exchange rates since the spring of 1995 have corrected earlier misalignments, and the present configuration is generally helpful and appropriate in view of relative cyclical positions. Specifically, the present relatively strong values of the currencies of the United Kingdom and the United States in comparison with the currencies of flexible than other policy instruments. Most capital-importing countries have not explicitly employed fiscal consolidation as a response to inflows, but as part of medium-term adjustment programs. More problematically, fiscal consolidation may also encourage capital inflows by easing concerns about possible future liquidity problems.
It is, therefore, not surprising to find that in addition to altering monetary, fiscal, and exchange rate policies in response to large swings in international capital flows, many counties have employed measures that discourage capital inflows or seek to influence their character. These measures are often generically referred to as “capital controls.” In fact, such measures range from prudential controls on the banking system, to market-based measures, all the way to quantitative controls on inflows and outflows (Box 1). In particular, these measures have included imposing or tightening prudential limits on banks’ offshore borrowing and foreign exchange transactions (Indonesia, Malaysia, and the Philippines), as well as taxing some types of inflows by requiring non-interest-bearing reserve deposits against foreign currency borrowing by firms (Brazil, Chile, and Colombia). For example, in Chile, the measures have taken the form of non-interest-bearing 30 percent reserve deposits placed at the Central Bank for a period of one year on direct foreign currency borrowing by firms.
In some instances, measures have taken the form of quantitative restrictions. For example, Colombia restricts foreigners from investing in the domestic bond maket. Malaysia responded to the inflow of speculative short-term bank deposits with the imposition of several quantitative measures. The most successful of these measures was the prohibition on domestic residents selling short-term money-market instruments to foreigners. In this case, abandoning the sterilization of foreign exchange intervention and imposing capital controls appear to have been successful in reducing domestic interest rates and short-term inflows. A number of countries particularly Asian developing countries, have restrictions on foreign borrowing by domestic companies and some have maintained prudential restrictions on financial institutions, such as restrictions on the open foreign exchange positions of banks.
It is dangerous to draw general conclusions about the consequences of “capital controls” without reference to the nature of such measures and the circumstances under which they were employed. On the one hand, comprehensive and detailed restrictions on capital inflows and outflows can have highly distorting effects, and such restrictions tend to erode over time. As the effectiveness of controls becomes weaker, authorities may be tempted to intensify them, increasing their distortionary effect.
(Changes in reserves as a percent of the balance in the capital account)1
The year in parentheses next to each country respresents the first year of the surge in inflows. A minus sign indicates reserve losses.
Does not include 1994.
The year in parentheses next to each country respresents the first year of the surge in inflows. A minus sign indicates reserve losses.
Does not include 1994.
On the other hand, measures to discourage excess short-term, foreign currency denominated borrowing by banks, such as increased reserve requirements, can be justified on prudential grounds—bank failures can have significant real effects, as well as fiscal consequences, when deposits are de facto guaranteed. Such measures also tend to have a more permanent effect. Some strong measures, such as taxes on short-term capital flows and bans on the purchase of particular types of securities, may be justified only as temporary measures until domestic financial markets and institutions become well established and resilient, while some other types of prudential measures and reserve requirements can be justified as more permanent features of the regulatory framework.
For example, a review of the Chilean and Malaysian experiences reveals that, in the short run, the volume of inflows was reduced by capital controls during episodes of higher exchange rate volatility and little or no sterilization, in 1991 and 1994, respectively. Furthermore, capital controls were undoubtedly less important than sound fundamentals in explaining the long-run success of several countries cited above in dealing with capital inflows.
In this regard, it should be noted that both Hong Kong and Singapore have managed large capital inflows without recourse to capital controls. Therefore, although capital controls may be helpful at times, they are not the distinguishing feature characterizing countries that have dealt successfully with capital inflows and outflows. Imposing capital controls on outflows during a crisis is interpreted as a measure of despair and hence is counterproductive. Furthermore, market participants tend to view the control of capital outflows as a confiscatory measure, which can be expected to increase future borrowing costs, 118 whereas preannounced taxes on short-term inflows avoid this stigma.25
Box 1.Restrictions on Capital Inflows and Prudential Requirements1
October 1994. A 1 percent tax was imposed on foreign investments in the stock market. It was eliminated on March 10, 1995.
The tax on Brazilian companies issuing bonds overseas was raised from 3 percent to 7 percent of the total. Eliminated on March 10, 1995.
The tax paid by foreigners on fixed interest investments in Brazil was raised from 5 percent to 9 percent, and reduced back to 5 percent on March 10, 1995.
The Central Bank raised limits on the amount of dollars that can be bought on foreign exchange markets.
June 1991. Nonremunerated 20 percent reserve requirement to be deposited at the Central Bank for a period of one year on liabilities in foreign currency for direct borrowing by firms.
The stamp tax of 1.2 percent a year (previously paid on domestic currency credits only) was applied to foreign loans as well. This requirement applied to all credits during their first year, with the exception of trade loans.
May 1992. The reserve requirement on liabilities in foreign currency for direct borrowing by firms was raised to 30 percent. Hence, all foreign currency liabilities have a common reserve requirement.
June 1991. A 3 percent withholding tax was imposed on foreign exchange receipts from personal services rendered abroad and other transfers, which could be claimed as credit against income tax liability.
February 1992. Banco de la Republica increased its commission on its cash purchases of foreign exchange from 1.5 percent to 5 percent.
June 1992. Regulation of the entry of foreign currency as payment for services.
September 1993. A nonremunerated 47 percent reserve requirement to be deposited at the Banco de la Republica on liabilities in foreign currency for direct borrowing by firms. The reserve requirement is to be maintained for the duration of the loan and applies to all loans with a maturity of 18 months or less, except for trade credit.
August 1994. Nonremunerated reserve requirement to be deposited at the Banco de la Republica on liabilites in foreign currency for direct borrowing by firms. The reserve reserve requirement is to be maintained for the duration of the loan and applies to all loans with a maturity of five years or less, except for trade credit with a maturity of four months or less. The percentage of the requirement declines as the maturity lengthens; from 140 percent for funds that are 30 days or less to 42.8 percent for five-year funds.
March 1991. Bank Indonesia adopted measures to discourage offshore borrowing. It began to scale down its swap operations by reducing individual banks’ limits from 25 percent to 20 percent of capital. The three-month swap premium was raised by 5 percent.
October 1991. All state-related offshore commercial borrowing was made subject to prior approval by the government and annual ceilings were set for new commitments over the next five years.
November 1991. Further measures were taken to discourage offshore borrowing. The limits on banks’ net open market foreign exchange positions were tightened by placing a separate limit on off-balance-sheet positions.
Bank Indonesia also announced that future swap operations (except for “investment swaps” with maturities of more than two years) would be undertaken only at the initiative of Bank Indonesia.
September 1994. Bank Indonesia increased the maximum net open position from 20 percent of capital to 25 percent, on an average weekly basis. Individual currency limits were no longer applied.
June 1, 1992. Limits on non-trade-related swap transactions were imposed on commercial banks.
January 17, 1994–august 1994. Banks were subject to a ceiling on their non-trade- or non-investment-related external liabilities.
January 24, 1994–August 1994. Residents were prohibited from selling short-term monetary instruments to nonresidents.
February 2, 1994–August 1994. Commercial banks were required to place with Bank Negara the ringgit funds…
In sum, shifting international capital flows can represent large shocks to small open economies, occasionally amounting to more than 10 percent of GDP in one year. The policy response to large and volatile capital flows may require multiple instruments, including measures that seek to discourage capital inflows or change their character, and coordination of policies, monetary, fiscal, and exchange rate, to ensure that recipient countries can derive benefits without incurring much of the costs.
Partnership for Sustainable Global Growth
The following “Declaration on Partnership for Sustainable Global Growth” was adopted at the conclusion of the forty-seventh meeting of the Interim Committee of the Board of Governors of the IMF, September 29, 1996.
The Interim Committee has reviewed the “Declaration on Cooperation to Strengthen the Global Expansion,” which it adopted two years ago in Madrid.1 It notes that the strategy set out in the Declaration, which emphasized sound domestic policies, international cooperation, and global integration, remains valid. It reiterates the objective of promoting full participation of all economies, including the low-income countries, in the global economy. Favorable developments in, and prospects for, many industrial, developing, and transition economies owe much to the implementation of sound policies consistent with the common medium-term strategy.
The Interim Committee sees a need to update and broaden the Declaration, in light of the new challenges of a changing global environment, and to strengthen its implementation, in a renewed spirit of partnership. It attaches particular importance to the following:
- Stressing that sound monetary, fiscal, and structural policies are complementary and mutually reinforcing: steady application of consistent policies over the medium term is required to establish the conditions for sustained noninflationary growth and job creation, which are essential for social cohesion.
- Implementing sound macroeconomic policies and avoiding large imbalances are essential to promote financial and exchange rate stability and avoid significant misalignments among currencies.
- Creating a favorable environment for private savings.
- Consolidating the success in bringing inflation down and building on the hard-won credibility of monetary policy.
- Maintaining the impetus of trade liberalization, resisting protectionist pressures, and upholding the multilateral trading system.
- Encouraging current account convertibility and careful progress toward increased freedom of capital movements through efforts to promote stability and financial soundness.
- Achieving budget balance and strengthened fiscal discipline in a multiyear framework. Continued fiscal imbalances and excessive public indebtedness, and the upward pressures they put on global real interest rates, are threats to financial stability and durable growth. It is essential to enhance the transparency of fiscal policy by persevering with efforts to reduce off-budget transactions and quasi-fiscal deficits.
- Improving the quality and composition of fiscal adjustment, by reducing unproductive spending while ensuring adequate basic investment in infrastructure. Because the sustainability of economic growth depends on development of human resources, it is essential to improve education and training; to reform public pension and health systems to ensure their long-term viability and enable the provision of effective health care; and to alleviate poverty and provide well-targeted and affordable social safety nets.
- Tackling structural reforms more boldly, including through labor and product market reforms, with a view to increasing employment and reducing other distortions that impede the efficient allocation of resources, so as to make our economies more dynamic and resilient to adverse developments.
- Promoting good governance in all its aspects, including by ensuring the rule of law, improving the efficiency and accountability of the public sector, and tackling corruption, as essential elements of a framework within which economies can prosper.
- Ensuring the soundness of banking systems through strong prudential regulation and supervision, improved coordination, better assessment of credit risk, stringent capital requirements, timely disclosure of banks’ financial conditions, action to prevent money laundering, and improved management of banks.
The Committee encourages the Fund to continue to cooperate with other international organizations in all relevant areas. It welcomes the recent strengthening of Fund surveillance of member countries’ policies, which is an integral part of the strategy. It reaffirmed its commitment to strengthen the Fund’s capacity to fulfill its mandate. It will keep members’ efforts at achieving the common objectives of this strategy under review.
Annex II Other Comments
Comments on Selectivity and Presentational Issues
1. A general comment on the report concerns its selectivity in reporting criticisms of the Fund’s approach to surveillance, and at times the substance of Fund policy advice. It is unclear what weight should be given to such criticisms, for example, the reference to “an academic observer’s” Criticism of the Fund’s line on currency boards (Chap. III, para. 21). The observer is cited as noting that the Fund had “bitterly opposed” a currency board in Indonesia while effectively “imposing” one in Bulgaria, without adequate explanation in his view. In fact, the Fund had explained to the authorities in considerable detail the reasons for the inappropriateness of a currency board in Indonesia in early 1998 (including shortage of foreign reserves, likely encouragement of capital flight, and the urgent need for extensive bank and corporate restructuring). It had also been made clear to the authorities that some form of fixed exchange rate arrangement could become appropriate at a later stage. This could have been acknowledged in the report.
2. In several instances the report refers to a complaint by officials that IMF staff “were seen as coming with a preconceived framework” and with a “one-size- fits-all” approach (Chap. III, para. 6; Chap. IV, para. 15). The report notes that the impact of Fund advice was enhanced when missions were able to “adapt the advice to the particular situation” (Chap. IV, para. 15). It would have been useful for the report to elaborate on this and provide concrete examples that describe the circumstances in which Fund staff recommended a set of policies that did not take into account country-specific situations.
3. The report does not delve sufficiently into the treatment of statistical issues and the role statistics play in the context of the surveillance exercise. This is relevant in the context of the views expressed by some small states that “too much time was devoted to data issues rather than policy advice” (Chap. III, para. 46). The report could usefully have provided some general background information for a balanced discussion of statistical issues that have a bearing on surveillance. This is particularly important given the Board’s assessment that “the effectiveness of surveillance depend [s] critically on the timely availability of accurate information” and major institutional initiatives in this area in light of the crises in Mexico and the Asian countries.1
The Focus of Surveillance
4. The paragraph headed “Scope and Coverage” (Chap. III, para. 41) states that, in addition to traditional macroeconomic demand-side topics, surveillance has become involved in microeconomic and supply-side matters such as trade liberalization. This is a misunderstanding of trade liberalization as addressed in Fund surveillance, which is based on establishing and sustaining an outward, market-oriented policy environment consistent with an appropriate macroeconomic framework. This is fundamental to the macroeconomic and trade performance of the great majority of Fund members. Article I of the Articles of Agreement suggests that this is central to the Fund’s purpose. In fact, the language of Chapter V (para. 29) seems to confirm this view and contradict the earlier statement. The same argument would apply also to the statements on tax policy and expenditure in the same paragraph.
5. The report’s references to the discussion of military spending in Fund consultations (Chap. I, para. 25) might usefully have taken note of the limitations that the Board has placed upon the extent to which these issues can be discussed in the context of Article IV consultations.
6. The discussion of the Fund’s evaluation of equilibrium exchange rates (Chap. I, para. 32) does not take into account the considerable work done in recent years by the Coordinating Group on Exchange Rates (CGER), reported, for example, in the Occasional Paper on exchange rate assessment by Isard and Faruqee.2 While not wishing to oversell the role of CGER, the Fund’s evaluations of exchange rates have been used as a basis for specific policy recommendations and public statements.3
7. The statement that there is “no attempt by the Fund itself to develop a comprehensive set of policy recommendations” in the context of the WEO is not accurate. Since 1993, the first chapter of each WEO has contained a comprehensive overview of policy issues and recommendations akin to the staff reports for Article IV consultations.
8. Our perspective is that the policy assessments provided through bilateral (Article IV) and multilateral (WEO, G-7 notes) surveillance are closely coordinated, with the Surveillance Committee chaired by management playing the deciding role when there are differences in view between area and functional departments (Chap. II, para. 6). Moreover, the Surveillance Committee meets regularly to review both Article IV briefs and staff reports, but also the main multilateral documents, not just on an ad hoc basis as earlier suggested.
9. With respect to the proposal that the Fund discontinue its work in the area of bankruptcy legislation (Chap. III, para. 39), our experience demonstrates that the development of an effective bankruptcy regime is critical to the Fund’s efforts to strengthen members’ financial systems and involve the private sector in the resolution of members’ balance of payments difficulties. On the operational level, the need for effective bankruptcy legislation has been recognized in a growing number of Fund-supported programs. On the policy level, the importance of the Fund’s work in this area has been recognized in the communiques of the Interim Committee and in the decision establishing the Fund’s policy on contingent credit lines.
Mission Frequency and the Reduction of Workload
10. We find the report overly optimistic about the potential for a reduction of the scope of surveillance activities in order to relieve the workload on the staff (Chap. V, para. 70). We are skeptical that the recommendation to better focus the surveillance process will have any significant effect on the overall workload. In a world in which many factors affect macroeconomic policy, the list of topics that might be seen to be “directly relevant” (Chap. V, para. 29) may be a long one in any given case. Although further progress can undoubtedly be made in collaborating with other international institutions and in more clearly delineating the respective areas of responsibility, this progress is likely to be incremental. Thus, the recommendations of the report relating to more frequent and/or continuous surveillance, more regional surveillance, more discussion of capital account issues, more focus on policy priorities and tradeoffs, etc., would likely have significant implications for staff resources that would not be offset by savings in other aspects of the surveillance process. These resource implications of the report’s recommendations should have been assessed and presented to the Board.
Role of the Executive Board and Proposals for Restructuring the Executive Board
11. On the Board Committee proposal, it is not evident that committees would save (rather than use up) Directors’ time (Chap. V, para. 110). In particular, the proposal for committee reports would certainly be labor intensive for someone. There would be an efficiency gain at the end—that is, when the full Board meets—only if at that stage Directors refrained from extensive, prepared, presentations. But this idea has been floated before, and even adopted, but never actually implemented. The two-step briefing process could similarly lead to further demands on an already stretched Board and staff, and, if not strongly managed, it could lead to a proliferation of topics for the mission, rather than a narrowing.
12. The proposal that the Board approve the set of topics to be discussed by missions would be a significant departure from the current division of responsibility between management and Board (Chap. V, para. 32), and would create an anomalous situation where policy issues facing a country would be discussed with the Board before they are discussed with that country’s authorities.
13. The report should not have referred to surveillance as a form of technical assistance or development aid (Chap. I, para. 8). Surveillance is distinct from the provision of technical assistance, and is not a form of development aid.
14. It should also be noted that Fund missions may meet with nongovernmental representatives in member countries only with the consent of the relevant authorities (Chap. V, para. 83).
15. Coming on the heels of the external evaluation of research in the Fund, we note some interesting differences in views on what the Fund’s priorities should be in recruiting staff (Chap. II, para. 47 and Chap. V, paras. 86 and 87). Not surprisingly, the evaluation of research stressed the importance of recruiting staff with strong interests in research. On the other hand, one of the recommendations of this evaluation is that the Fund should place more emphasis on recruiting staff with policy experience, and less on academic qualifications, at all levels. This seemingly contradictory advice points to the importance of the Fund setting priorities and organizing itself against the background of a strategic vision of its role in the international community. Evaluations—both internal and external—that focus too closely on one particular activity may lose sight of this. In our recruitment of experienced economists, who account for well over half the Fund’s hiring of economists, the emphasis is on policy experience already. The suggestion to place more weight on policy experience in the recruitment of Economist Program participants is simply not realistic: the average age of Economic Program entrants is 29; it is very difficult to have substantial relevant policy experience by that age.