Global Economic Outlook and Policy Responses

1. After what appeared to be a bright start in 2002, the world economic situation has worsened since our Spring meetings, leading to a downward revision of global growth and to increased uncertainty, with the balance of risks slightly tilted towards the downside.

2. This scenario presents a special challenge to all of us economic policy-makers, who have the responsibility of trying to avoid downside risks from materializing. I want to stress the need that member countries respond in a cooperative and coordinated fashion with appropriate policies to help the global economy resume a path of stronger growth in a relatively short-time horizon. I expect that, with stronger global growth, capital flows to emerging markets will increase from the very low present levels.

3. The lack-luster prospects for corporate profitability in mature markets set the tone for an overall increase in risk aversion, affecting especially financing conditions for riskier investments both in advanced economies and emerging markets. The hesitant recovery of the United States together with the absence of a compensatory strengthening of economic conditions in Europe and Japan have made the global economic recovery more protracted and uncertain than we thought in the Spring. The evolution of the international price of oil is another source of risk to the global economy. Heightened uncertainty and augmented volatility in this market has increased the likelihood that energy prices may continue to be a source of inflationary pressures in 2002.

4. In the United States, while rapid inventory adjustment since the fourth quarter of last year and an initial rebound in consumer and business confidence, following the swift response to last September events, yielded an amazingly high 5 percent GDP growth in the first quarter of 2002, economic data released since the Spring has been indeed less than reassuring. Notorious cases of corporate fraud and failures gave rise to growing skepticism about the quality of corporate governance and accounting practices in the United States, sparking a wave of uncertainty regarding the quality of reported earnings of major corporations, affecting further corporate investment, and risking the speed and strength of economic recovery. The United States authorities, however, acted promptly approving wide range corporate reforms that should help restore investors' confidence.

5. To prevent further deterioration in corporate investment, avoid undermining the incipient consumption-led recovery, and limit spillovers to the financial sector, a sufficiently supportive macroeconomic policy stance needs to be maintained. The main lever of such strategy should continue to be monetary policy. Even if the current supportive policy stance does not prevent equity markets from falling further, it could help to insulate housing prices, the key factor behind the impressive resilience of household consumption. The current stance of U.S. fiscal policy may be adequate from a cyclical perspective, and should continue to be supportive in the presence of sizeable downside risks. Nonetheless, securing long-term fiscal viability is important to allow for an orderly and gradual adjustment of the external current account.

6. The Japanese economy has almost stabilized this year with an impulse from net exports making up for the still-anemic domestic demand, and a modest improvement in corporate profits. This improved situation from last year's poor performance, however, may not be sufficient to avoid deflation from materializing again. There are considerable downside risks, including the continued appreciation of the yen, the ongoing corrections in equity markets, and the existing vulnerabilities in the corporate and banking sectors. Accelerating structural reforms in these sectors, while pursuing a broadly neutral fiscal stance and maintaining reinforcing monetary conditions, would help to bring about an early end to deflation and a resumption of long-overdue sustained growth.

7. In the euro area, the recovery is not yet firmly established, with domestic demand still weak, and the resilience of export-led growth may prove elusive given the pace of global recovery. This hesitant recovery, together with balanced risks to price stability, recommend that monetary policy remains on hold for the time being. Given the difficult budgetary positions in several countries, there seems to be little room for maneuver on fiscal policy. However, faster implementation of structural reforms, especially in the labor and product markets, would enhance productivity and potential output growth.

8. At this critical juncture of the world economy, moving decisively against protectionism and distortionary subsidies becomes all the more important to improve the prospects for a durable global recovery. Numerous developing countries have embraced significant trade liberalization, making important inroads in mitigating the previously existing anti-export biases and in opening their economies to market contestability of potential imports, but unfortunately still face high tariff and non-tariff protection against their competitive exports. An important role for the Fund is to continue its efforts to promote increased international trade integration as a means to foster global prosperity.

9. I, therefore, very much welcome that the WEO made trade liberalization one of its main themes this year. As mentioned in the document, industrial countries provide extremely high levels of agricultural support to their farmers, which averaged about 30 percent of gross farm income involving a total cost of US$ 300 billion last year. These agricultural support schemes impose high costs to consumer and taxpayers in industrial countries and to producers in developing countries. The WEO estimates that the static gains from multilateral agricultural liberalization both by industrial and developing countries would amount to US$ 128 billion, while the dynamic gains arising from higher investment and faster productivity growth associated with agricultural liberalization would be several times that amount. Brazil, for instance, would have welfare gains equivalent to 0.72 percent of its GDP and experience an improvement of 2.6 percent in its terms of trade. While the duty to liberalize is incumbent on all, industrial and developing countries alike, given their level of wealth and the small size of their agricultural sector, industrial countries should take the lead in multilateral liberalization. I praise the Fund for this type of enlightened advocacy work and strongly suggest it should become a common practice of its bilateral and multilateral surveillance.

10. Heightened global risk aversion and low appetite for risk have made it significantly more difficult for emerging markets to tap international capital markets, despite their willingness to continue implementing robust macroeconomic policies. In Brazil, despite continued strong macroeconomic policies and a major turnaround in the external accounts, financial market variables came under increasing pressure since the second quarter, as political uncertainties about the future course of economic policies were compounded by the generalized increase in global risk aversion arising from the sharp downturn in mature equity markets. Access to international capital markets, which had already become more constrained, worsened significantly in July and August. The credit squeeze reached a point where even foreign trade lines, traditionally resilient in earlier balance of payments crises, were significantly affected.

11. The Brazilian government strengthened policies further and sought IMF support for a new Stand-By Arrangement. Expressions of support by the leading presidential candidates to the core elements of the program contributed to mitigate concerns about policy continuity. At the same time, helping to dispel concerns about debt sustainability, recent technical studies have confirmed that, with the maintenance of current levels of primary surpluses, even under very conservative assumptions concerning GDP growth and real interest rates, the debt dynamics would follow a declining path in the medium term. The pledge received by the government from leading international banks operating in Brazil to sustain their general level of business in the country, including trade lines, is an important indication that international investors' confidence is giving signs of improvement.

12. While the exchange rate and bond spreads are still overshooting at distressed levels, as policy uncertainties following the presidential transition dissipate further, and access to international capital markets improves, upside risks could materialize. A substantial adjustment has taken place in the external current account as a result of structural changes that are taking place since the floating of the real in 1999. Given efficient import substitution, imports of goods and services have become less sensitive to the level of economic activity, suggesting that, as growth accelerates to closer to potential, the Brazilian economy can remain in a strong external position. Since 1998, the year before the adoption of the floating exchange regime, the current account deficit has been halved from US$33.5 billion to US$16.7 billion in the 12months ending in August. The current account deficit is now at 3.2 percent of GDP, down from a peak 5 percent. Based on the latest figures, the central bank is currently projecting a trade surplus of US$9 billion in 2002, and US$11 billion-US$12 billion in 2003, with the current account deficit expected to narrow further and continue to be financed largely by inflows of foreign direct investment as in the last several years.

13. The credit squeeze faced by the major emerging markets is now affecting other economies in Latin America. Within our constituency, and in close collaboration with multilateral institutions, Colombia is adopting important measures in order to strengthen its fiscal position and advance its reform agenda. Once those efforts yield the anticipated result of normalizing access to external financing, growth should resume and debt sustainability indicators significantly improve.

Improved Surveillance, Crisis Prevention and Resolution

14. I compliment the Managing Director for his comprehensive report on the IMF's work in surveillance, crisis prevention and resolution, and share his view that a central mission for the Fund is making surveillance more effective. High quality policy dialogue with member countries, focused on the Fund's core areas of expertise and with careful assessment of the social and political constraints impinging upon policy options, is the single most important factor to enhance the effectiveness and impact of surveillance.

15. In an increasingly integrated world, characterized by complex and profound linkages amongst national economies, domestic economic and financial policies of individual countries become all the more internationally relevant, making surveillance one of the major functions of the Fund. Both the prevention of crises in emerging market countries and the global and regional impact of policies of the major industrial countries need to be placed high in the hierarchy of concerns to be addressed by the Fund's bilateral and multilateral surveillance.

16. Surveillance and program reviews in program countries have tended to be more effective in terms of generating concrete policy actions than surveillance in non-program countries, especially industrial countries. Both activities share many complementarities and common broad objectives. Achieving an independent scrutiny of the overall economic strategy and of the policies followed under IMF programs is better done by strengthening the independent review function performed by the Policy Development and Review Department (PDR) than by separating program and surveillance activities. Formal separation between surveillance and program activities could lead to significant efficiency losses, create problems of coordination, and confusion for the authorities and market participants. However, in the specific cases such as off-track programs, repeated programs, or prolonged use of Fund resources, it may make sense to have a fresh pair of eyes looking into the overall economic strategy and policy options.

17. While significant progress has been made on crisis prevention, the inexorable incidence of financial crises should continue to pose the challenge of improving the Fund's capabilities in the area of crisis resolution.

18. Good progress has been made in enhancing the Fund's capacity to assess debt sustainability, with the development of a more systematic operational framework for such assessments. However, as the Managing Director correctly concludes in his report, the interaction of numerous factors --future macroeconomic prospects, political and social realities, and the availability of financing-- makes any assessment of sustainability a complex exercise that is ultimately predicated on judgment, rather than on the mechanistic application of debt sustainability models.

19. The capacity to lend above normal access limits in the exceptional circumstances of capital account crises has allowed the Fund to respond flexibly with exceptional financing when there was domestic willingness to undertake the required policy adjustment. This has been a major positive aspect of the efforts to improve the international financial architecture and to further global integration. While the counterfactual of lack of exceptional Fund financing cannot be observed, the results of exceptional access have been generally positive. In most cases, investors' confidence has been restored, capital flows have been stabilized, and external vulnerabilities have been reduced, with countries being now in a stronger position than prior to Fund assistance. Moreover, the evidence of moral hazard in IMF loans is, at best, mixed, as acknowledged by Kenneth Rogoff in a very persuasive article to the September issue of the Finance & Development where he suggested that a major indication against the presence of moral hazard is the fact that "IMF loans have had a stubborn habit of being repaid in full", and I might add, in some cases, being repaid ahead of the scheduled payment dates.

20. I welcome the Board's decision not to establish any new exceptional access or exposure limits, as well as most of the Managing Director's proposals to strengthen the decision-making process in the case of exceptional access. I also welcome, in this connection, the further consideration of the appropriate maturity of Fund lending in capital account crises, and of the related issue of the appropriate mix of resources between Supplemental Reserve Facility and Stand-By Arrangement.

21. Since the Spring meeting the Fund has been discussing two proposed approaches to improve the process of sovereign debt restructuring—a contractual approach—through further use of collective action clauses (CACs) in bond contracts; and—a statutory approach—with the discussions on a number of legal, institutional, and procedural aspects related to a proposed Sovereign Debt Restructuring Mechanism (SDRM).

22. I continue to believe that a contractual approach based on greater use of existing collective action clauses in new international sovereign bond issues offers better prospects of practically improving the current process for restructuring international sovereign debt than the SDRM. The most promising route to increase the use of existing collective action clauses seems to be a joint and constructive effort that would need to have the ownership of major institutional investors and bond issuers. The timing for a concrete move towards greater use of collective action clauses would have to be carefully considered, given the current adverse conditions of international capital markets for emerging markets.

23. While there seems to be support, among a number of members, for a statutory debt restructuring mechanism, I remain unconvinced that the benefits of such initiative will be higher than its potential costs. The delay and reluctance of sovereigns to recognize a given debt position as unsustainable are caused by the uncertainties in determining when debt becomes unsustainable, and by the very high economic dislocation and reputational costs associated with debt restructurings, and not by the lack of a procedural mechanism to secure collective action on the part of the creditors, or to offer temporary protection against the enforcement of creditors' rights. Neither of these difficulties would be reduced by an SDRM. On the other hand, holdout creditors and creditor litigation do not seem to have been major impediments in recent sovereign bond restructurings in Russia, Ukraine, Pakistan, and Ecuador.

24. I agree, however, that if the statutory approach were to evolve into a sovereign debt restructuring mechanism, the scope of debt under it should be limited to international sovereign debts governed by foreign law, with explicit and upfront exclusion of domestic debt, as it has been agreed by the Executive Board in its last discussion.

25. Establishing an international dispute resolution forum linked to the Fund would be beset by conflict of interest problems, given the Fund's position as a creditor, main policy advisor, and possible future lender. If the idea is to make such a body to function independently from the Executive Board, the Board of Governors, Management, and the staff, then it might be better and simpler to establish such mechanism not linked to the Fund at all. Some of the dispute resolution functions envisaged for the new organ would require considerable powers to be discharged, including investigative powers to inquire into motives of creditors and into the actions and motives of the sovereign, which is not permitted under many domestic court systems. Another problem is that, while achieving uniformity of legal interpretation is important, ideally all disputes concerning trade governed by a single governing law should be resolved the same way. It is not clear how the interpretations of an international dispute resolution forum would be reconciled with those of the domestic courts of the governing law if both differ.

26. Amending the Articles of Agreement is a complex and cumbersome process that does not seem the most appropriate means of implementing the SDRM, since the issue falls outside the Fund's purposes, and was never envisaged by members when they originally subscribed to the Articles. If an SDRM is to be established, this should be done by a completely new international agreement rather than by amending the Fund's Articles of Agreement. There are, therefore, many unresolved issues that need to be carefully studied before any decision is made.

27. Meanwhile, I should like to repeat what I said in my oral intervention during the Spring meetings, namely extending to other jurisdictions the attachment immunity for foreign central bank assets which already exists in the United States and England, and the adoption of rules to protect from attachments payments flowing to and from clearing systems like Euroclear, Clearstream, and DTC. If we cannot implement these simpler measures, how could we do even more?

Streamlining Conditionality and Enhancing Ownership

28. I wish to pay tribute to the Managing Director for his leadership in the discussions toward enhancing the effectiveness of Fund-supported programs through streamlining and focusing conditionality and improving national ownership of economic reforms. After almost two years of intensive, comprehensive, and constructive debates the Executive Board has come to a consensus and issued new Conditionality Guidelines which represent a significant improvement over the earlier 1979 Guidelines. Fewer, more focused, and better-designed conditionality, together with a stronger national ownership, should contribute to more successful implementation of Fund programs. The implementation of new Guidelines on Conditionality should be periodically assessed by the Executive Board.

Size and Distribution of Fund quotas

29. Over the years, the aggregate quotas of the Fund increased at a considerably slower pace than world GDP, international trade, and international capital flows. Compared to the original size of the Fund with respect to world GDP, the aggregate quotas are nowadays three times smaller than when the Fund was established.

30. Judgments regarding the resource adequacy of the Fund and a possible quota increase need to be made in a forward-looking manner. The costs associated with a possible shortfall or excess of Fund resources are sharply asymmetric as, on the one hand, additional resources would imply only modest incremental costs for creditor countries, whereas, on the other hand, the insufficiency of resources would likely have substantial detrimental repercussions to global prosperity. While views of the membership still differ in relation to the adequacy of the current size of Fund resources, I believe that the present volatile international financial environment and the objective of preserving the Fund's preparedness to respond to a sudden impairment of market access relying primarily on its own resources signal towards a need for additional resources.

31. Besides an overall shrinking size, in the case of some emerging market member countries, actual and calculated quotas do not adequately reflect anymore the relative magnitude of their economies and their level of integration in the world economy. This is particularly so because the actual weight of GDP in the quota formula has fallen from around 35-40 percent during the 1980s to only 29 percent now. This has dampened the effect of the faster growth of some countries. These problems are obvious in the case of some emerging markets that received exceptional access, such as Korea, Turkey, and Brazil. We hope that, independently of the decision regarding the Twelfth General Review of Quotas, agreement can be reached on a new formula to calculate quotas that is simpler and more transparent than the current multiple formula.

Combating Money Laundering and the Financing of Terrorism

32. I wish to commend the Fund, the Bank, as well as member countries, for the significant progress achieved, during the last six months, on the implementation of the action plan to combat money laundering and the financing of terrorism. Such progress is highlighted, in particular, by the conditional addition of the FAFT 40+8 standard to the list of standards and codes considered relevant by the Fund; the conditional approval of a 12-month pilot project for AML/CFT ROSCs; the near completion of a new comprehensive and unified assessment methodology; and, most importantly, the very positive response of member countries to the international efforts in this area as reflected by the use of the new methodology in 21 voluntary FSAPs, by the 48 responses to the detailed questionnaires on AML/CFT, and by the 152 responses by members to the Secretary's invitation for information regarding the steps taken by these members in response to the IMFC's request.

33. Our constituency will continue to be a strong supporter of the efforts to combat money laundering and the financing of terrorism, as we have been doing since these issues started to be discussed at the Fund.