Prospects for the World Economy and Policy Response

The tragic September 11 events have precipitated on an already weak world economy. The US economy began experiencing a slowdown at the beginning of the summer, following the sharp deceleration of the technology cycle and the bursting of the bubble in financial markets, and was suffering from the negative consequences of the oil price rise.

Today, the global picture is worrying, not only because forecasts have been repeatedly revised downwards, but especially because of the pervasiveness of the downturn. The extension of the global slowdown, as well as its widespread negative consequences, also reflect the dramatic increase in interdependence that has taken place over the recent past. Market integration has proved to be a powerful channel of transmission of disturbances, which, as we are now beginning to understand, go well beyond traditional trade linkages to include financial linkages and the transmission of changes in expectations from one area to another.

The terrorist attacks have increased the already high degree of uncertainty, further deteriorating the state of business and consumer confidence. The direct effects of September 11 on risk aversion might become subdued soon, as recent indications from financial markets seem to suggest. It should be stressed, however, that in the short term all forecasts are inevitably fraught with uncertainty until more reliable information about the unfolding of the cycle becomes available. Given an environment where fundamentals, both in the US and in Europe, remain sound, the role of policy is to strengthen confidence and support long-term expectations, while standing ready to use all available room for maneuver.

As for the longer term, there are reasons to believe that the productivity growth potential that has been underlying the buoyancy of the US economy until recently will remain in place to a large extent, leading to a substantial pick-up of activity once confidence resumes.

EU growth is affected by the US slowdown more than originally expected, as negative shocks work their way through different channels, including trade, financial markets, and expectations. However, EU fundamentals remain strong and, in the short term, lower oil prices and the recent further easing of monetary conditions will support demand of both consumers and enterprises. On the fiscal side, continuing adjustment in fiscal position increases the room for automatic stabilizers to play a role within the framework of the Stability and Growth Pact.

In the current situation, in addition to a supportive monetary policy as inflation decelerates, the main contribution of the EU economy to global growth rests in the acceleration of structural reforms that will raise output and employment potential, and allow for full exploitation of the sizable productivity gains associated with information and communication technologies, along the lines laid out in Lisbon in March 2000. Key reform areas include labor and product markets, pension systems and healthcare, and financial markets.

Progress in spending cuts is necessary to carry out a sizeable reduction in the fiscal pressure, instrumental in boosting growth, and meeting the challenges of the ageing European society. Credible reform announcements will support market expectations of a gradual yet irreversible increase in the potential growth rate and sustain confidence and activity.

Emerging market economies and developing countries are also being hit hard by the current slowdown. Most emerging market economies are suffering simultaneously from declining world demand and from increasingly difficult access to financial markets, to which they are not expected to recover access until well into 2002. The overall picture is mixed, however, as prospects for Asian economies are somehow less of a source of concern than those in Latin America. In addition, risks of contagion appear to be limited as we see more diversification by investors, and borrowers are increasingly tapping local currency capital markets.

Poor countries, with little or no access to financial markets, are feeling the consequences of the declining world demand as well as of declining commodity prices. It will be crucial to maintain support to poverty reduction strategies, and resources available for PRGF should be closely monitored and increased if necessary.

A more open global trading system would significantly contribute to poor countries' growth perspectives and would represent a very positive factor to enhance their debt sustainability. Technical assistance to poor countries represents a key factor in exploiting the benefits of a more open trading system. Indeed, the interaction of financial support, greater market access, and capacity building is the correct way to increase poor countries' ability to improve their growth prospects.

The Role of the Fund

In the aftermath of the terrorist attacks, the risk for the insurgence of financial crises calls for a more proactive role of the IFIs in general, and of the IMF in particular, to respond promptly and in a flexible way to potential disruptive events that may affect member countries.

The Fund should reinforce its activities for crisis prevention. This means above all strong and effective surveillance. Surveillance should embrace macroeconomic, structural and financial policies, including the adoption of standards and codes. At present, the adoption of internationally agreed upon standards still lags behind in many countries, while the status of implementation lacks adequate consideration within Art. IV consultations.

Surveillance is the key for crisis prevention. Its main objective is to detect vulnerabilities. Past experience shows that most crises arise from vulnerabilities that have not been addressed in a timely manner. Therefore we ask staff to strengthen their rigorous surveillance exercises that may sometimes result in sharp judgments about the soundness of policies.

One of the areas where work has not proceeded as expected is exchange rate policy. Past experience shows that the appropriate choice and orderly performance of exchange rate regimes is crucial in crisis prevention and management. We encourage the Fund to further proceed in the assessment of this issue.

In order to perform its role effectively the Fund must rely on more effective and more timely ex ante sustainability assessment of debt position.

We do not think that stronger surveillance reduces "ownership." We are convinced, rather, that through more effective surveillance the Fund can help increase countries' awareness on how to address their areas of vulnerability. The Fund should create the right incentives for countries to adjust policies in a timely fashion.

We welcome the progress achieved in streamlining conditionality, with particular reference to "micro-conditions." However, we are convinced that what is relevant in designing a program is, on the one side, to create preconditions to regaining market access and, on the other side, to safeguard Fund resources. Structural conditionality therefore should represent an essential component of Fund's conditionality, while remaining well-focused, effective and legitimate.

Structural conditionality could be assessed at two levels to determine whether to include specific measures: a) structural measures should strengthen macroeconomic policies and the stability and resilience of the financial sector; b) the inclusion of other structural conditions would need to be proven.

We are pleased to learn that the liquidity of the Fund is adequate to face potential demand, even in an adverse scenario. However, we cannot rely only on official resources for crisis resolution. It should be clear to market participants that they should not expect to be bailed out.

Private sector involvement should be a crucial component both in crisis prevention and in crisis resolution. Much further progress is needed in this area. We agreed on a framework for PSI in Prague in 2000, but up to now we have not succeeded in making it fully operational. The EU has made concrete proposals with its Common Understanding on PSI, which, moving from the Prague framework, tries to identify operational procedures while allowing for the necessary discretion.

The Fund should carry out more work in order to define a viable and more transparent procedure to deal with crisis resolution and broaden the spectrum of solutions available when a crisis unfolds. Effective crisis management must be based on a clear assessment of the financing gap, the medium-term sustainability of countries' policies and debt positions, the degree of private sector involvement, and the implications for markets and for the overall performance of the economy.

In the absence of such a framework the implementation of effective PSI becomes too complex. The Fund must seek a better understanding of issues such as the identification of market-friendly solutions to help alleviate a country's position; the response strategy in cases when voluntary solutions cannot be pursued or are inconsistent with the medium-term sustainability; the preconditions and the legal underpinnings for orderly stand-stills.

These are only a few of the issues needing more clarity that we confront when making a decision on how to fill the financial gap of a specific country.

In designing solutions to help countries face crises, a priority should continue to be the safeguarding of open and well-functioning financial markets. In this respect, the Fund should strengthen its work in helping countries liberalize their capital markets.

Well sequenced and orderly liberalization of the capital account is a key condition for sustaining growth. While specific cases may require specific analysis and policy design, this basic principle should remain at the core of policy advice and implementation.

Anti-Money Laundering and the Fight Against Terrorism.

One of the most worrying consequences of the September 11 events is the recognition of the vulnerability of the global system to the action of terrorists who have access to substantial financial resources. We need to respond with a concerted action to dismantle the terrorist network and destroy the financial basis of terrorism.

In this regard, Italy is implementing UNSC Resolutions 1267 and 1333, and is freezing bank accounts and other assets belonging to individuals listed in the Resolutions. Italy is not alone in this effort: implementation of the Resolutions was decided on by the European Union and the lists of institutions and individuals connected to terrorism is being continuously updated and enlarged on the basis of new information. The strong initial input provided by the US through Presidential Executive Orders is now being matched by information coming from our own domestic investigations, the results of which are now being made available to other countries. Italy has created the "Comitato di sicurezza finanziaria" (Financial Security Committee) to coordinate the fight against terrorist financing, and to strengthen the cooperation with similar bodies in other countries.

Beyond stressing the present action against terrorist organisations, I would like to recall the importance of adopting all the instruments necessary to fight the financing of terrorism world-wide, starting with the implementation of the UN Convention against the financing of terrorism and with UNSC Resolution 1373. Italy has signed the Convention against the financing of terrorism and is committed to ratifying it expeditiously. We are also working within the EU towards the implementation of UNSC resolution 1373. Meanwhile, Italy has modified its legislation to conform to all the recommendations contained in the UN instruments. We welcome the setting up of the UN Counter-terrorism Monitoring Committee and are ready to support its efforts to ensure a timely implementation of UN instruments.

At its recent extraordinary Plenary Meeting, the Financial Action Task Force has agreed to widen its mandate so as to encompass terrorist financing, and has added eight special Recommendations to protect financial systems from being abused for financing terrorism. As a founding member of the FATF, Italy is committed to adopting and applying rigorously these eight special Recommendations, and I would urge all non-FATF countries to modify their legislation to comply with them. Italy is ready to assist countries willing to strengthen their financial systems.

Money laundering and the financing of terrorism are issues that affect countries at all stages of development. There is no doubt that the Fund should be involved in the world-wide effort for a more secure and abuse-free international financial system. It is hard to imagine a distinction between financial stability and financial integrity. A strong financial system is one that is transparent, well monitored, and open. The world does not need uniformity. It needs diversity. But it needs standards, too.

I am therefore particularly pleased with the recent endorsement by the IMF Executive Board of a set of measures that will enhance the Fund's involvement in Anti-Money Laundering Work and Combating the Financing of Terrorism. This represents a concrete move towards a more comprehensive approach to AML work that will make action more effective by increasing consistency and avoiding duplications. Consistency of action does not necessarily imply identical actions across countries, but requires that action rest on common normative, organizational, and financial standards.

While the proposed actions are fully consistent with the Fund's mandate to preserve global financial stability, strengthening cooperation with the FATF will increase the efficiency of action by the Fund in an appropriate sharing of roles and tasks. FATF/Fund cooperation is bound to be mutually reinforcing and beneficial to both institutions. In this context, I welcome the preparatory work that the Fund is carrying out with the Bank and the FATF for an AML ROSC module. I expect this module to have the high quality customary to the IMF, and to be used under the Fund's supervision.

Of particular importance is the role of the Fund in providing and coordinating, together with the World Bank, technical assistance (TA). TA is a crucial instrument for countries with limited resources and capabilities to upgrade their AML systems to meet international standards. The pleas for more resources to improve capacity in this sector need to be answered. This should be a concerted effort. Italy, for its part, has established a sub-account, within the Fund, that will provide resources for TA. A share of these resources would be directed to supply TA in sectors related to AML and combating financial terrorism.

There is broad agreement that an effective AML system and fighting the financing of terrorism are our ultimate goals. The Fund has the appropriate instruments (research, TA, surveillance, conditionality) to provide a substantial contribution to this fight. All such instruments are to be used flexibly and without a priori commitments and limitations, and their use is to be monitored as we gather further experience on the process on a case-by-case basis. I look forward to the next review of the Board on this matter.

The Italian Economy

In 2001, the Italian GDP is expected to grow by 2 percent; 0.4 percentage points less than what was projected in the Economic Financial Planning Document (DPEF 2002-2006) presented in July and almost 1 percent less than in 2000. The slowdown in the global economy, with the ensuing deterioration in business confidence, has taken a toll on Italy's short-run growth prospects. In particular, investment in machinery and equipment is expected to increase by only 2.5 percent (7.8 percent in 2000); investment in construction by 2.7 percent (3.6 percent in 2000). At the same time, consumer demand also rose at a slower rate than expected, mainly because of the impact of unanticipated inflation on disposable income.

The prospects for 2002 are still surrounded by high uncertainty, as the fallout from the terrorist attack on the global economy is hard to predict. Even if the world economy recovers somewhat in 2002, the impact on Europe and Italy will remain significant. At the same time, the continuing strength of economic fundamentals in Europe and the US, the subdued behavior oil prices, and a prompt policy reaction throughout the industrialized world offer some hope that the global slowdown will be relatively short-lived. The international economy is therefore expected to recover in the second half of the year. Based on this assumption, Italian GDP is projected to grow by 2.3 percent in 2002, slightly higher than the average in the euro area.

Over the whole year, domestic demand is expected to contribute to much of output growth. Investment demand should receive a boost from the recently enacted fiscal incentives and from a set of measures aimed at revitalizing infrastructure investment. In this context, investment in construction is projected to rise by 3.5 percent while that in machinery and equipment is expected to increase by 5.7 percent.

Consumer demand should also grow at a sustained rate thanks to the fall in inflation, a pattern of tax cuts targeted to low-income groups, and the continuing improvement in the labor market situation. The rising employment content of growth shows that labor market reforms are bearing fruits. Unemployment should continue to fall even in 2002, helped by steady domestic demand and a continuing effort toward improved regulations.

Over the medium term (2003-2005), the re-establishment of a favorable international environment and the implementation of a broad-based structural reform program are expected to push the Italian growth rate to about 3 percent. Fiscal and welfare reforms should be associated with a fall in the tax burden and a better allocation of public spending, with a positive impact on growth potential.

Turning to public finances, the general government borrowing should fall to 1.1 percent of GDP in 2001 against 1.5 percent last year, and to 0.5 percent in 2002. The downward trend in the structural balance will be more significant, paving the way therefore for meeting the target of a balanced budget in 2003. Over the next few years, the government will continue to implement a comprehensive spending reform program, with a view to achieving a decline in primary expenditures by 4 percentage points of GDP in 2006. Reductions will be brought about in all major spending categories including health, public employment, subsidies and pensions, with the exception of those for the poorest beneficiaries which are scheduled to rise. This will create room for sizable tax cuts and tax structure simplification in order to foster growth and improve income distribution. From 2005, the budget will move into a slight surplus (0.2 percent of GDP) to allow fiscal policy to fully play its countercyclical role.

The Outlook in the Other Countries of the Constituency

The Albanian economy has continued its stabilization with GDP growth averaging at about 7-8 percent, the domestically-financed deficit being reduced from 6.4 percent in 1998 to 3.2 in 2000, and inflation dropping sharply from double-digits to the 2-4 percent band set by the authorities. FDI flows have also significantly increased - with projected figures for 2001 reaching 5.2 percent as a share of GDP, mainly reflecting future growth potential.

Authorities have maintained the momentum on structural reforms, moving aggressively on the path of privatization, improving significantly tax collection, streamlining the civil service, opening the economy to foreign trade flows, and creating a business environment conducive to investment and growth.

Economic activity in Greece has continued to expand at a rapid pace during 2001 as the impact of the global slowdown has been offset by robust growth in domestic demand and a remarkably strong performance of exports. For the year as a whole, real GDP is projected to increase by just over 4 percent, a rate of increase more than twice as high as the European Union average and only marginally lower than that registered in the preceding year. Growth has continued to be driven primarily by business and infrastructural investment. In addition, the substantial easing of monetary conditions associated with Greece's entry into the European Economic and Monetary Union as of the beginning of 2001 has contributed to hefty growth in both consumer spending and residential investment. The rate of inflation accelerated somewhat during the first half of 2001 but slowed to below 3 percent recently. Meanwhile, fiscal discipline has been maintained with the general government balance moving into a slight surplus in 2001, for the first time in recent history, and the public debt declining to below 100 percent of GDP. Despite the increasingly uncertain external environment, these favorable trends are expected to be sustained in the year ahead, thanks in part to the ongoing implementation of EU-supported major investment projects and the acceleration of other structural reforms, as well as the preparations for the 2004 Olympic Games.

Malta experienced sustained growth in 2000 and the beginning of 2001, but the economy has slowed down considerably in the second half of this year due to the worsening of global conditions. Growth has been supported by the continued positive dynamics of exports and strong consumer demand, albeit with some deceleration in tourism. Inflation, at less than 2 percent at the end of 2000, has remained subdued, even though it has shown recently some signs of acceleration, mainly due to rising import prices. External accounts have deteriorated in 2000, mostly because of exceptional factors related to investments carried out by the largest foreign-owned company based in the country. The current account imbalance is being partially reversed this year. Looking forward, the effects of the September events in the US could impact the Maltese economy on two fronts. On one side, tourism, an important source of revenues, will probably be negatively affected. On the other, the stronger slowdown of the world economy will continue to depress exports, particularly in the important electronics sector. Growth in 2001 will therefore have to rely more substantially on domestic demand.

On the policy side, the government is adhering to the fiscal consolidation started in 1998-99 and aiming at a decided reduction of the fiscal deficit by 2004. Monetary policy has been eased over the summer to counteract the slowdown in the economy. In a broader perspective, the government remains strongly committed to EU accession and has made important progress to this end.

In Portugal, economic prospects have also been revised further downwards since last Spring. Current projections for GDP growth in 2001 stand in a range of between 1.5 and 2 percent (down from 3.2 percent in 2000), reflecting both a deeper-than-expected slowdown in domestic demand - matched by a further deceleration of imports - and a faltering external demand. Against the background of the imbalances that have emerged in the Portuguese economy following the change in its macroeconomic environment, the slowdown in the pace of domestic demand may be regarded as part of a welcomed re-adjustment process. This process is expected to persist in 2002.

Reflecting, in particular, sharp price increases in non-processed food and a base effect resulting from the pattern of domestic energy price adjustments, the annual inflation rate is projected to increase this year to around 4.3 percent (from 2.8 percent in 2000). On the basis of current projections, inflation should decline in 2002, reverting to about 2.7 percent.

The budget deficit initially targeted for 2001 (1.1 percent of GDP) has been revised to 1.7 percent, basically in light of the clearly less-favorable growth scenario that has been materializing since the time of its adoption. The State Budget proposal presented to Parliament projects the budgetary deficit to decline to 1.3 percent of GDP in 2002 (a revision of the same magnitude of the target set out in the last Stability Program).

San Marino's economy has enjoyed a sustained rate of growth, projected by the IMF at around 7.5 percent for the current year. This is similar to the rate recorded for 2000. In addition, inflation remains subdued. While the net asset position of the public sector is still sound, a central government budget deficit was recorded in 2000, equal to 2.8 percent of GDP according to the Eurostat Methodology.

A new government, which has taken office in recent months, has adopted a thorough agenda aimed at preserving the traditional high competitiveness of this small but highly diversified economy. In this regard, a series of measures aimed at taming current expenditures has been envisaged and is being implemented in order to reach a balanced budget for 2003. Meanwhile, the San Marino authorities are fully committed to the fight against money laundering and have already ratified major international conventions. Along similar lines, the authorities are also committed to continue improving their statistical base, according to the international guidelines set up by the International Monetary Fund.