News Brief No. 01/98

News Brief: Statement of the Managing Director on the Situation of the World Economy and the Fund Response

October 5, 2001

The Managing Director of the International Monetary Fund, Horst Köhler, today made the following statement to an informal meeting of the IMF's Executive Board on the situation in the world economy and the IMF's response. The statement is being sent to the Governor for each of the IMF's 183 member countries.

"In the aftermath of the terrorist attacks of September 11, a coordinated international response is needed to deal with weaknesses in the world economy and the new risks in the outlook. The Fund, its 183 member countries, and the international community more generally, will need to respond with sound policies to reduce the likelihood of a sustained slowdown, and make sure we are ready to deal with a deeper and longer downturn if it does emerge—thereby limiting the disruption and attendant human costs.

"In the immediate future, economic policies will need to be framed in an environment of unusually large uncertainty. There are good reasons to expect that the current deterioration of economic conditions may be relatively short-lived, with an upturn commencing in the first half of 2002. These include the improved fundamentals that were already present in the global economy, the policy response that has taken place, and the scope for further policy adjustments, if necessary. But there is also a non-negligible probability of a worse outcome, involving lower growth and increasing financing difficulties for many countries. In this context we see the following framework for a coordinated response:

• Industrial countries are key engines of growth in the world economy, and their economic policies should help to sustain demand. The steps already taken to ease monetary policy in the major industrial countries are an appropriate and welcome response. If necessary, they should use the further room for easing available. On fiscal policy, automatic stabilizers should be allowed to work as a first step. Some action to ease discretionary fiscal policy may also be appropriate, while taking care that easing is consistent with medium-terms needs of the country. An acceleration of structural reforms that are needed to raise growth potential over the medium term would contribute importantly to rebuilding confidence.

• Developing and emerging market countries will need to reexamine their policies, recognizing that there will be little market tolerance for weak fundamentals. Strong policies will position these countries to benefit from a supportive macroeconomic stance in the industrial economies, but there is also likely to be a need for additional external financing.

• The IMF is prepared to play its role of providing advice and additional financial support, where necessary, to those members that have (or adopt) suitable policies, as part of a joint international effort to strengthen confidence in the global economy.

• Other members of the international financial community, including multilateral development banks, bilateral official creditors, and private creditors, as well as other agencies will all need to be prepared to do their share—including provision of needed trade credits and Paris Club action where warranted.

Global Outlook and Risks

"Notwithstanding the uncertainty, a number of developments indicate that a more pronounced than expected economic slowdown is underway across much of the IMF's membership. Even before the attacks on September 11, the global situation was weak, with a synchronized downturn across all major regions. As noted in the IMF's latest World Economic Outlook publication, developments in the advanced economies were characterized by a significant further drop in financial asset valuations, widespread declines in industrial production, including sharply lower production in the high-tech sector, an appreciable weakening of business and consumer confidence and signs of a generalized weakening in demand. Developing and emerging markets were already experiencing slackening external demand, low commodity prices, and increasing risk aversion and worsening conditions in international financial markets.

"In the aftermath of the attacks, there will be an impact on activity, particularly in the United States, but also elsewhere. The extent and duration of this impact will depend critically on developments in consumer and business confidence, which are difficult to assess at this stage. The situation of emerging markets and developing countries has become more difficult, with reduced access to global financial markets, and deeper demand and commodity price declines. In addition, security concerns after the attack are translating into higher costs for airline transport (related to security measures), lower tourism owing to safety concerns, and higher prices and higher transportation costs for merchandise. Finally, the impact on oil prices could be substantial in either direction.

"There are intensified downside risks to world economic and financial conditions, and we need to keep these in mind in deciding on appropriate policies for the period ahead. The Fund staff has examined an "adverse case" scenario, in which the return of private sector confidence is delayed, with output growth just over one percent lower in 2002—both globally and in the industrial countries—compared with the WEO projections. The adverse scenario also considers the implications if international capital markets are closed to many emerging economies through the fourth quarter of 2001, with a gradual reopening of capital market access starting in the first quarter of 2002. Commodity prices would be lower as a result of the decline in demand, and, in line with the direction of early price movements, this scenario is based on an appreciably lower oil price.

"Some important regional vulnerabilities can be identified. The U.S. has been the main engine of world growth for the last decade. A further softening in the U.S. will significantly affect nearby Latin American and Caribbean countries, and tourism centers will be hard hit. Emerging market debtor countries around the world will be affected by the longer period of global risk aversion. Emerging Asian countries will feel the impact of lower demand in the industrial countries, adding to the already ailing high tech sector and weakness in Japanese demand. Lower demand and commodity prices further cloud the outlook for primary producers, although lower oil prices would be an offset to net fuel importers, which include many of the poorest countries.

"The staff has also considered the effects of a possible increase in oil prices. With an assumption of a significant rise in oil prices, the net fuel importers would lose the offset noted above, and the impact on many developing countries would be significant. Higher oil prices would, of course, have a positive impact on petroleum exporters, including some emerging market borrowers.

The Role of the Fund

"The Fund has appropriate tools and flexibility to respond to a weakening world economy. In the context of the overall approach of surveillance and lending, the Fund can take a number of concrete steps. We are closely monitoring the situation, with early and proactive dialog with member countries. I encourage all members to review their policy frameworks in light of recent developments, and to approach the Fund early to discuss the implications of these developments for their economic policies. The appropriate response by the Fund will depend on the member countries involved and the nature of the problems they confront:

• Advanced economies have a key responsibility to ensure that macroeconomic and financial policies support an early return to sustainable growth and financial strength, as noted above. There has been a significant easing of monetary policy in the United States and most other advanced countries, whose impacts should be felt increasingly in the coming months. In Japan, there is still scope for more decisive monetary action. In addition, the restoration of confidence in Japan will clearly require resolute steps on banking sector and corporate restructuring. Recent U.S. fiscal measures should also help to underpin economic activity, while permitting continued progress in unwinding savings-investment imbalances over the medium term. In the euro area, automatic stabilizers should be allowed to work fully. Monetary policy should be vigilant and, if necessary, use the room for additional easing. In addition, consumer and investor confidence would be enhanced by an acceleration of structural measures to improve growth potential.

• Emerging market economies are exposed to shocks both to the current and capital accounts, and the availability of private financial flows is a key vulnerability. Sound economic policies, including early adjustment when needed, is imperative. For its part, the Fund can: (i) approach eligible countries to encourage consideration of Contingent Credit Lines (CCL) to help them face potential contagion effects in capital market conditions; (ii) consider new programs supported by the Supplemental Reserve Facility (SRF) and/or stand-by arrangements in those economies where it is deemed appropriate; and (iii) for countries with existing programs, consider augmenting or rephasing access when the policy framework is strong and appropriate to the emerging circumstances (24 countries presently have GRA-supported programs, including 2 blended with PRGF resources).

• Developing economies are exposed to current account shocks derived from weaker commodity prices and lower demand for their exports of goods and services. The Fund stands ready to help these countries in designing appropriate policy responses. In cases where additional financing from official sources may also be needed, the Fund can act in a variety of ways. Stand-By Arrangements can be discussed very quickly, or augmented and rephased, to respond to a wide range of BOP problems that might emerge. In appropriate cases, these could take the form of first credit tranche arrangements with lower conditionality. Some countries may qualify for lending from the Compensatory Financing Facility (CFF) for shortfalls in export earnings (including tourism) or cereal import excesses. A CFF would normally be in the context of a stand-by arrangement, but could potentially be stand-alone if the member's BOP position was otherwise satisfactory.

• Low-income economies are exposed to shocks similar to those of other developing countries. While the policy response in terms of adjustment may be the same, the terms of additional financing should not. The Fund would stand ready to make available additional concessional resources, using the Poverty Reduction and Growth Facility (PRGF) wherever a three-year program is in place or can be agreed early on (there are now 40 PRGF arrangements in place). For members not ready to undertake a three-year structural reform program, stand-by arrangements may be considered. We could also encourage countries to seek additional concessional resources where necessary from other official sources (e.g. IDA and bilaterals) and work with creditors to encourage a positive and well-coordinated response, including assistance under the HIPC Initiative.

"While the Fund's existing financial instruments and policies appear adequate, the Fund will be ready to adjust its policies if necessary. One step that could be taken if events so indicate, would be to introduce a temporary oil element within the CFF to allow compensation for higher import costs through this facility (as was done during the Gulf war crisis). The Fund's response to a deeper global deterioration would need to be developed, however, and might well extend beyond this.

"Because the deterioration could affect a large proportion of the membership, it is important to consider aggregation effects in selecting the appropriate mix of adjustment and financing. In global circumstances of weaker demand, it will be more difficult—and problematic for the world and regional economies—for individual countries to adjust their external financing needs by contracting domestic demand or depreciating the value of their currency. The aggregated effect of such policies could be detrimental. On the other hand, if new balance of payments problems emerge in an idiosyncratic fashion, then this concern would be lessened.

"While the prospective demand for Fund resources is sensitive to the size of the downturn and assumptions about market access for emerging market countries, the Fund has the capacity to respond to the evolving situation in its member countries in the period ahead. The staff has considered the implications of the WEO baseline and the adverse case scenarios described above in light of the Fund's liquidity position. The main conclusion is that, with a reasonable mix of financing and adjustment, the Fund's liquidity position makes us well-positioned to deal with the additional need for Fund resources in these scenarios over the next 1-2 years. More extreme outcomes are unlikely, although they cannot be excluded, and the Fund's liquidity situation will be kept under close review.

"For the PRGF, recent developments have made more urgent the need to complete the financing package for the interim PRGF. If demand exceeds earlier tightly constrained projections, it may be necessary to mobilize additional PRGF subsidy and loan resources or to accelerate the interim PRGF at the expense of the level of self-sustained PRGF operations. We should not let that eventuality hinder our support for low-income members in the immediate circumstances.

The Worldwide Response

"The Fund's response should be part of a concerted response by the international community. The engagement of a whole spectrum of institutions would be needed, in particular:

• Multilateral development banks' participation will be essential for appropriate sectoral advice and because additional project and program financing and budgetary support may be needed in some countries. For this reason, I have joined with the Presidents of the World Bank and the four regional development banks to set out our coordinated response to these events.

• Export credit agencies will need to play their role in helping to assure the continued availability of trade finance.

• The Paris Club may need to be involved as the solution to the external financing needs of some members may entail rescheduling of obligations to official creditors.

• Reengagement of the private international capital markets will be a key to a more rapid recovery. The adoption of appropriate policies in industrial countries and a strong policy response in emerging market countries should help facilitate an increase in the supply of funds for emerging markets. The Capital Markets Consultative Group, which is scheduled to meet again in mid-October, will be an important vehicle for reaching out to the private sector.

• To bolster confidence, the launching of a new trade round is of critical importance. It is equally important not to lose momentum on various industrial country initiatives to increase the access of the poorest countries to their markets.

• Efforts to vigorously implement global anti-money laundering initiatives should be fully endorsed. In concert with the broader efforts of other institutions, the Fund is further strengthening its role in the anti-money laundering effort. In light of the terrorist attacks, Management has just established an internal Task Force of Fund staff under the chairmanship of a Deputy Managing Director to examine urgently the Fund's contributions to the worldwide effort against money laundering.

"To lead this coordinated approach to the deteriorating world situation, the international community should meet. I therefore support holding an early meeting of the International Monetary and Financial Committee and the Development Committee," Mr. Köhler said.