The Global Economy -- Outlook, Risks and Policy Responses

The improving global economic outlook is the result of skillful policy responses to the sharp and synchronous economic slowdown and the tragic events of last year. Timely easings of monetary policy, the operation of fiscal automatic stabilizers, and--where appropriate--discretionary fiscal stimulus, including tax cuts on labor income, all helped avert a global recession, and contributed to a faster than expected recovery.

The advanced and developing countries alike would suffer if high oil prices were to derail the nascent global recovery. Even if the oil spike is only temporary, the global recovery is not a certainty, and making it more robust will require skillful policy management in all countries. The most important and difficult short-term goal is to keep the recovery from foundering, and making it stronger and sustainable.

At this point, absent inflationary pressure, it would be prudent for most countries to keep interest rates low for some time longer, until we are sure the recovery is on a solid footing. Of course, the behavior of oil prices could complicate the conduct of monetary policy. But instead of trying to suppress completely the first-round effects of higher oil prices on the general price level, it will be more important to prevent the second-round effects from being transmitted through higher wage growth and other channels.

Since the monetary easing will not be reversed until there is further evidence that the recovery is gathering momentum, there is no need for an additional fiscal stimulus in the United States. Now the priority of U.S. policymakers should be to return to the strong fiscal position that supported the robust performance of the U.S. economy in the 1990s.

In the Euro Area, the present policy stance is appropriate, as well as supportive of rapid economic recovery. The Stability and Growth Pact (SGP) has given most Euro Area countries enough room to use automatic stabilizers, and adherence to the SGP's limits has continued to cement the credibility of the fiscal policy framework. Looking ahead, it is important for the countries that have not yet reached their medium-term SGP target to use the next recovery to improve their underlying fiscal positions as fast as possible. Fiscal consolidation in good times will be rewarded with more room for fiscal flexibility in bad times.

Unfortunately, there is cause for concern in Japan, which remains in deep recession. The standard macroeconomic policy tools can do little to stimulate domestic demand. The corporate sector is suffering from deflation, and the new nonperforming loans of banks are increasing faster than the old ones can be resolved. As long as this situation persists there is little hope of recovery. Decisive progress in cleaning up the bad loans, the closing of loss-making businesses, and further nonstandard measures by the central bank to stop deflation are all urgently needed.

The main goal for the medium term is an orderly correction of the present large external current account imbalances among the major currency areas. Protectionist measures must be avoided. It is very much in the interest of both industrial and developing countries to avoid a disruptive adjustment causing large exchange rate movements among the major currencies that could lead to turbulence in the international financial markets.

For their part U.S. policymakers must continue the prudent fiscal and monetary policies of the 1990s. Japan, which will play a crucial role in the correction of current account imbalances, must get its domestic demand growing once more, by confidence-enhancing and growth supporting structural reforms and by macroeconomic policies as supportive as the need for medium-term fiscal consolidation allows. Europe, too, has room for further progress with structural reforms to raise the growth of potential output. Stimulating employment growth by reforming labor market incentives could be especially important. The integration of financial markets has to follow a strict and ambitious timetable. A more dynamically growing euro area would not only help reduce the global external imbalances, but would also benefit the transition economies of central and eastern Europe.

The outlook for the European Union accession countries is positive. Progress towards EU membership has encouraged responsible macroeconomic policies and good progress with structural reforms. This has helped shield these countries from the global economic slowdown. Their progress with privatization, and their attractiveness to foreign direct investment, have allowed them to finance their current account deficits without borrowing. Even so, they must keep their current account deficits within reasonable limits and remain attractive to foreign direct investment.

It is also encouraging to see that Turkey is making important progress in resolving its financial crisis. Inflation is falling rapidly, economic activity has started to recover, and the indicators of investor confidence have significantly improved in recent weeks. Despite the difficulty of the challenge, it is now likely that with a sustained policy effort, Turkey's ambitious program objectives will be achieved.

Growth in the countries of the Commonwealth of Independent States (CIS) was remarkably unaffected by the global slowdown in 2001, thanks to solid growth in Russia and helped in many cases by improved macroeconomic stability and policy implementation. The central challenge facing the countries of the region is still to accelerate progress with structural reforms, which with some exceptions has been relatively disappointing in recent years.

Many of the emerging market economies of Southeast Asia have greatly reduced their external vulnerability: their currencies_ exchange rates are now more flexible, their foreign reserves higher, and their current accounts stronger. In these countries, monetary and fiscal policies can be focused on supporting economic activity, while maintaining the effort to complete their structural reforms.

The large dependence on external financing keeps many emerging market countries in Latin America vulnerable to adverse market sentiment. It is important for these countries to continue their efforts to become less vulnerable to external shocks, and further strengthen their policy frameworks and their credibility.

In Argentina, the situation is worrisome. The authorities must devise and implement a program for decisively addressing the deep-rooted weaknesses, particularly in the public finances, that led to an unsustainable external debt. The Fund must continue to assist Argentina with policy advice, and financial support when warranted. Such a program will facilitate the restructuring of Argentina's debt in cooperation with its creditors.

In Africa, growth in the low-income countries has remained relatively strong. This is a manifestation of the enormous benefits of ending military and civil conflicts. But Africa's agenda remains daunting: in a number of countries, military conflicts, political autocracy and poor governance continue to obstruct progress in reducing poverty and improving economic performance. Three sets of conditions must exist together for there to be a significant improvement of economic performance: (a) the termination of military conflicts and the strengthening of democracy; (b) solid policy management, sizeable debt reduction, and more aid; and (c) open access to industrial country markets.

Strengthening Crisis Prevention

The Fund's universal surveillance mandate makes it different from all other institutions. The purpose of this surveillance is to influence countries' policies for their own betterment and the common good. In this sense, the Fund's mandate is political--insofar as this means helping to make the necessary possible. More countries should publish their Article IV Consultation reports. This contributes to the quality of the domestic policy debate and sharpens the discipline of financial markets.

The Fund's surveillance examines countries' compliance with their Article IV obligations. Because it must cover the whole world with limited staff resources, we must be cautious in extending Fund surveillance beyond the basics--the exchange rate, fiscal and monetary policies, and the financial sector. Macroeconomic relevance, external viability, vulnerability to balance-of-payments and financial crises, and relevance for the stability of the international monetary and financial system are suitable criteria for selecting the topics of surveillance.

The Fund must continually strengthen its expertise on countries' financial sectors, and become a leader in preserving the soundness of financial systems. The Financial Sector Assessment Program (FSAP) is a useful enhancement of Fund surveillance. As a means of heading off financial crises, it should become an integral part of Fund surveillance.

Surveillance, program negotiations and reviews are interlinked. In order to strengthen the effectiveness and accountability of surveillance, the Executive Board must give the staff explicit instructions for maintaining a reasonable separation between program work and surveillance.

Strengthening Crisis Resolution

Our implementation of the PSI framework agreed in Prague in September 2000 has not yet been completely satisfactory.

The Fund would increase the transparency and the guidance to the private sector by publishing a systematic account of the private sector's role in the resolution of crises during the last five years. Fund's analyses of countries' external debt sustainability must be further refined. Access policy should be based on relevant macroeconomic parameters and on the results of a refined debt sustainability analysis. We encourage further progress toward reforming the process of sovereign debt restructuring through the use of collective action clauses and by further examining the innovative proposals of the First Deputy Managing Director.

The IMF's Role in Low-Income Countries

The speed and vigor of low-income country authorities in drafting and implementing Poverty Reduction Strategy Papers (PRSP), and the enthusiastic reactions of other stakeholders, show that this approach has been successfully launched. But the recent comprehensive and very lively review of the PRSP process, not surprisingly, showed that the PRSP approach must be improved in many ways.

First, full transparency must be achieved to demonstrate that the macroeconomic strategies promoted by the PRSP and the Poverty Reduction and Growth Facility (PRGF) are developed and chosen by the countries concerned, and are not schemes dictated from outside.

Second, greater efforts are needed to secure the involvement of all stakeholders, including business associations, trade unions, and organizations that truly represent the poorest members of society.

Third, fiscal revenues must be increased, and public spending must be better controlled and geared towards poverty reduction.

Fourth, stronger analysis is needed of the effects on poverty of major policies and programs, including PRGF-supported programs. The input of the poorest groups of society is most important and must be actively solicited.

And fifth, respect for human rights should be one of the "best practices" encouraged by PRSPs. There is growing evidence of a correlation between economic development and respect for human rights, convincingly documented by Nobel Prize winner Armatya Sen. Many low-income countries have included measures to increase respect for human rights in their PRSPs, a trend to be encouraged by the Bretton Woods institutions.

Steady progress is also being made in implementing the Initiative for the Heavily Indebted Poor Countries (HIPC). But more will be needed to achieve debt sustainability.

Several countries are still far short of external debt sustainability, due to delays in implementing their PRSPs and their PRGF-supported programs. And for some that have completed the HIPC process, debt sustainability cannot be guaranteed because their exports are low and not diversified enough, or their external debt management is still deficient. Countries that have not yet reached the decision point must persevere to qualify for debt relief. The strong efforts of the Democratic Republic of Congo and of Burundi towards that goal are commendable and should be supported.

The response of many non-Paris Club official creditors to the HIPC Initiative has been disappointing. Six years after its launch, many still have not agreed to provide debt relief. They should follow the good example of those who have. The most disappointing are official and private creditors who are litigating against HIPCs to recover their claims in full. We call on them to show solidarity with the international community.

The success of the Initiative also depends on the volume of aid and concessional financing coming from the advanced countries. The pledges made in Monterrey by the United States and the European Union are welcome, but too small to meet the Millennium Development Goals by 2015. All countries must fully open their markets to the exports of the poorest countries, as the European Union agreed to last year. The advanced countries should also follow up on the commitment made in Doha to hold comprehensive negotiations on phasing out all export subsidies to agriculture.

Another important priority is to finish ratifying the Fourth Amendment to the Article of Agreement, which will double the amount of SDRs allocated so far. This Amendment was approved by the Executive Board, the Interim Committee, and the Board of Governors in 1997, and since then has been ratified by 113 countries. Approval by one more--the United States--would make this amendment effective.

Increasing growth and reducing poverty in the low-income countries requires that all countries pursue substantially improved policies for a long time. The Fund must actively push such policies for advanced, middle-income, and low-income countries in the course of dealings with governments, and report the progress to the Executive Board and the IMFC.

Streamlining Conditionality and Enhancing Ownership

Fund-supported programs should always include as few measures as possible but as many as are necessary to durably solve balance-of-payments problems. Most countries with strong track records can get along with a small number of conditions. For others, a longer list of conditions, including growth-promoting policies, is needed, both to restore the confidence of the financial markets and to ensure the sustainability of their debt. Some countries needing structural reforms find detailed conditionality more useful than streamlined conditionality, not only to guide implementation, but also to inspire stronger ambition and discipline inside and outside the government. We must keep the Fund's structural conditionality flexible enough to suit individual country circumstances.

Combating Money-Laundering and the Financing of Terrorism

Implementing anti-money laundering (AML) measures and combating the financing of terrorism (CFT) are high priorities for the international community. The Bretton Woods institutions have a central role to play. The Fund must undertake a significant part of the work, both by helping devise a uniform methodology for assessing countries' compliance with the AML/CFT standards of the Financial Action Task Force (FATF) and by conducting such assessments, and by providing technical assistance. A single methodology covering all 48 of the FATF recommendations is needed. Its application should be voluntary, cooperative, and uniform for all members. This fits well with the Fund's traditional role as the machinery for consultation and collaboration on international monetary problems and for helping countries protect their financial systems against misuse.