| The extent and speed of the recovery of the U.S. economy appears to be adding yet another pleasant surprise to the many offered by the U.S. economy in recent years, but the risks cannot be overlooked. The excess capacity in key sectors, over-leveraged households and corporations, and the sizeable current account deficit and the implied overvaluation of the dollar, are factors that may eventually limit a U.S.-led global recovery. While the U.S. economy remains the single engine of world economic growth, global imbalances keep on growing, and the critical question becomes how long can this process be sustained? The obvious way of correcting these imbalances would be through faster growth in other areas, but so far the obvious seems to have little prospect of materializing, as shown by the generalized reduction of growth rates during the recent U.S. slowdown.
Several vulnerabilities threaten the ongoing recovery. These include besides global imbalances, other potential sources of asset price misalignments and the cost-push effect of still another oil price shock. The stock markets in some industrial countries appear to be richly priced, with implicit expectations of earnings growth that seem difficult to fulfill. A sudden realignment of expectations and the ensuing price correction would seriously damage consumption and investment demand in industrial countries and affect global growth. In addition, the extremely grave security situation in the Middle East has increased the risk of a prolonged oil price shock, which would have a contractionary effect on global demand that could abort the ongoing recovery.
The vulnerabilities threatening the recovery, and the urgent need to integrate emerging market economies and developing countries in general into the global markets, implies that efforts to support growth should be consistent among all the major economies. Since the downside risks should continue to be the main policy concern, supportive demand policies should be maintained globally until the recovery has clearly taken hold. Aggregate demand is still weak, and there are ample output gaps to keep upward pressures on core inflation from becoming an immediate risk. As a general policy prescription, as long as inflationary expectations are stable and anchored by strong monetary institutions and credible policy commitments, monetary policy should play a more active role in stabilizing output through strong and opportune responses to cyclical fluctuations. In emerging markets, the scope for supportive macroeconomic policies is more limited, but they too should pay special attention to growth enhancing initiatives.
A group of industrial countries with relatively open economies, including the UK, Canada, Australia, the Nordic countries, and New Zealand, have shown remarkable resiliency during the slowdown and may become a strong force for the recovery of global growth. Due to size, however, the Euro area gives the most significant promise of contributing to global growth over the medium-term. But they should take more decisive actions, particularly in the structural front, to promote trade and financial integration and more flexible product and labor markets. Meanwhile, given the absence of inflationary pressures, policies should give a more decisive support to aggregate demand with a sufficiently easy monetary policy where risks are well balanced, and by allowing the full operation of fiscal stabilizers by targeting structural deficits rather than nominal ones. In the present phase of the cycle, this policy would support the recovery, and, after growth picks up, it would help control the pace of the expansion. Targeting structural fiscal deficits means that during the recovery, expenditure targets must be respected even when revenues exceed expectations, thus avoiding a pro-cyclical bias of fiscal policy.
Unfortunately, there is no indication that Japan will soon contribute to the global recovery, despite its sizeable fiscal stimulus packages and the zero interest rate policy, whose effects have been limited by a deflationary process that has increased real rates. Despite several attempts at corporate and bank restructuring, the credit market remains burdened by bad debts. A more in-depth evaluation of the policies implemented so far to revive the economy seems called for. In our view, structural reforms are especially important, including improving the accuracy of loan classifications, and redirecting credit accordingly. In addition, stronger actions in monetary easing remain essential for stopping the deflation. The symmetry of monetary policy targets applies particularly to Japan, where the deflationary spiral shows that containing inflation should not be the only goal of monetary policy.
While recovery is knocking at the door of most industrial countries, growth in most emerging markets is expected to remain relatively low in 2002, and even countries with recognized strong policies are not expected to show a rapid recovery until 2003. The external financing conditions generally faced by emerging market economies impose restrictions on their policies during a global slowdown. Many of them are unable to allow the automatic fiscal stabilizers to operate fully, and others may even have to submit to strong pro-cyclical fiscal adjustments, because their fiscal policy is constrained by limited financing. Monetary easing may be also constrained by the threat of a sharp currency depreciation, which in many countries poses risks for the fiscal position and for the financial system, as a result of public debt denominated in foreign currency and currency mismatches in private portfolios.
The latter two problems of foreign currency denominated public debt and the currency mismatches in the private sector, point to the need to establish markets for medium and long-term financial instruments in emerging market currencies. The private capital markets remain reluctant to subscribe issues denominated in emerging currencies, and do so only at short maturities. Perhaps the experience of some small industrial countries in creating markets for foreign debt in domestic currency could provide useful insights. Given unavoidable perceptions of inflationary risks in emerging market countries, systems of financial indexation may be necessary for the establishment of markets for long-term instruments denominated in domestic currency. Developing relevant international standards may be helpful to favor such a process. Emerging market countries have much to gain on the basis of sound policies. Nevertheless, they require additional assistance, both financial and technical, to adequately confront external shocks and to improve the development of markets to minimize their external vulnerabilities.
There is a tendency when evaluating the Latin American debt crises, to fall back on stylized generalizations that usually emphasize the lack of fiscal policy discipline as the ultimate cause of the problem while downplaying the importance of external shocks and financial vulnerabilities. Factors such as terms of trade shocks, mismanaged financial liberalizations, reversals in capital flows, and financial regulations in industrial countries that create a bias towards short-term loans, are among the exogenous factors affecting income, financing and market access that have also been important in the genesis of crises. These risk factors have not only been recognized, but several Latin American countries have made significant progress in reducing their vulnerabilities, through macroeconomic stabilization, structural reforms and institutional development.
Finally, to support global growth on a sustainable basis, trade openness, which has been the basis for global prosperity since the post-war period, must be increased. In particular, it is important to make progress in eliminating industrial countries' trade distorting subsidies, which are largest in sectors where developing countries have comparative advantages. A surge of protectionism in the industrial countries is also very damaging: to steep tariff increases and the risk of retaliations, should be added the intensive use of anti-dumping measures. One-third of the anti-dumping measures of the last five years were taken by only three developed countries, and this trend seems endless. To top it all off we must also factor in the additional barriers created by the terrorist threat and related security measures that entail higher transportation and insurance costs. Reversing this trend and implementing without delay multi-lateral and bi-lateral trade opening initiatives is crucial for averting the risk of stagnating global trade and the extremely harmful consequences for economic growth and the fight against poverty.
2. The IMF Policy Agenda
Strengthening crisis prevention and resolution
We agree that the current process for restructuring sovereign debt takes longer, is more damaging to the country and its creditors, and is less predictable than it should be. These are powerful reasons for considering an orderly restructuring mechanism for cases when sovereign debt is no longer sustainable. Debtor concerns about reputation issues and creditors' attempts to flee from heightened risk conspire to delay the payment interruption and increase political pressures on the IMF to continue lending even when debt is unsustainable. In addition, in the event payments are interrupted, the absence of such a mechanism makes it likely that opportunistic actions by some creditors will increase the difficulties of reaching a rescheduling agreement, extending the period during which the debtor country is excluded from the financial markets and subject to a deep crisis.
Developing a clear, simple and predictable sovereign debt restructuring mechanism (SDRM) with adequate incentives would significantly improve welfare. But this new restructuring framework should not be seen as leading to unnecessary defaults or broadly increasing the perceived risk of default. The challenges are to improve the analytical basis for judging debt sustainability and to develop a predictable debt restructuring mechanism, that would be used rarely, only in exceptional circumstances. The definitions of procedures to ensure that all the adjustment and financing efforts have been exhausted before the default is declared should complement progress in establishing this mechanism.
Among the features making an SDRM a more orderly solution than existing arrangements, the central one is clearly that it makes it easier for a majority of creditors to make a restructuring agreement binding on all creditors. We view the statutory approach and the amendment of the Fund's Articles of Agreement as the most efficient way of establishing a comprehensive collective action framework, and of setting up the independent judicial organ for verifying claims and the integrity of the voting procedure. The critical element is deciding what agent would have the legitimacy and the correct incentives to call for the stay, and we still see no clear solution to this problem which we think demands further discussion. The IMF could not unilaterally call for the stay, since as a creditor it can be seen as having incentives to manage the declaration of default so as to protect its own assets. Nor should the debtor country unilaterally declare the stay, since it may have incentives to avoid adjustment efforts or protecting its reputation. But the problem must be confronted, since market fears of an eventual payments interruption would aggravate the situation and precipitate the crisis through capital flight.
The statutory approach appears to be the most promising and comprehensive, but the discussions required to settle its details will surely take time. Meanwhile, the contractual approach appears likely to be an adequate complement, after the problems of costs, signaling, and coverage are solved. A contractual approach to debt restructuring should result from an international effort based on standards and agreements on which industrial and developing countries have collaborated. Issuing bonds with collective action clauses will probably involve additional financing costs. This burden should not be borne wholly by countries that are already struggling to secure external financing on reasonable terms. One possibility is for the extra cost entailed for program countries issuing this type of bonds to be borne by some international financial institution or arrangement. We must also confront the signaling problem, by finding ways to avoid the market's perception that this is a mechanism to prepare default. Here, a generalized introduction of collective action clauses in the bonds of industrial and emerging market countries, for instance, through a change in regulations in the issuing markets, would certainly help. It is also important for all countries -even those for whom debt problems seem remote-- to have the right clauses in their debt contracts. Finally, it is necessary to maximize the coverage of this mechanism by extending it to other liabilities, such as commercial loans, and to develop swap mechanisms that would permit the replacement of the stock of already issued liabilities.
The Fund has the great responsibility of ensuring that liquidity problems never cause a sovereign default. The development of adequate mechanisms for liquidity provision continues to be essential, including facilities that act as an international lender of last resort to provide support to countries that have sound policies but nonetheless confront contagion. Sound policy advice and technical assistance are also important for avoiding the deterioration of countries' financial conditions and limiting the risk of crisis. The main emphasis of the Fund's work should be crisis prevention rather than crisis resolution.
IMF surveillance
The prevention of crisis in individual countries is an important goal of Fund surveillance, a part of the wider objective of promoting a stable global macroeconomic environment conducive to stability and growth for the membership at large. A prerequisite of this is to adequately address systemic problems. Regional and multilateral surveillance are important in the identification of systemic risks. Surveillance is thus part of a process that helps countries to define an overall medium-term policy strategy leading to sustainable growth. As such, this process should help countries to define policy frameworks that are compatible with both national and international prosperity. When IMF policy advice is framed in this fashion it is likely to be more effective. Regrettably, the Fund's leverage for making its surveillance effective is asymmetric. Developing and emerging market countries in actual or potential need of Fund resources have a direct incentive to maintain an open dialogue with the Fund at the highest decision-making levels, but for other members with no need to use Fund financing, the possibility that the Fund's advice will influence policies is much smaller.
Capital account issues have rightly become a central part of surveillance concerns. On the one hand, the volatility of external financing creates significant risks for the emerging market economies, so that assessing the vulnerability of their external positions should be a central element of crisis prevention. On the other hand, the structural reforms required for the liberalization of the capital account and the appropriate sequencing for advancing towards a complete integration into globalized financial markets are critical elements for managing external risk. There exist no general prescriptions for appropriately sequencing the steps to international financial integration, nor is it reasonable to expect an immediate and unconditional liberalization of all restrictions. But the final objective is both generally applicable and clear: all countries should aspire to become integral parts of a global system of trade and finance.
On balance, we do not see enough justification for independent surveillance of program countries, which would put further stress on limited Fund resources, and could lead to conflicting signals in the Fund's policy advice, which should be unambiguous and preclude mixed interpretations. And finally, the Fund should strive, in the exercise of its surveillance responsibility, to strike the right balance between transparency and candor. Protecting its role as confidential advisor is critical if the Fund's policy advice is to have the impact that is generally expected from the surveillance exercise.
The IMF's role in low-income countries
The highly indebted poor countries that have opted for trade and financial integration and good policies are beginning to reap the first benefits in terms of growth and poverty alleviation, but their overall progress is too slow. We welcome the "twin pillar approach" to reinvigorating the fight against global poverty. Giving equal weights to the responsibilities of the low-income countries and the international community, while demanding coherence between aid and trade, are the keys to increasing the effectiveness of these effort. The low-income countries should adopt sound policies, strengthen their institutions and improve their governance. The international community should provide support through greater trade opportunities and the more effective delivery of increased aid flows. The provision of greater trade opportunities by increasing access to the markets of advanced economies is a necessary condition for breaking the vicious circle of stagnation, poverty and weak governance. Both the Doha Ministerial Conference and the recent Monterrey consensus have emphasized the essential role of trade for long-lasting poverty reduction.
The fully participatory process used in designing poverty reduction strategy papers (PRSP) has created a strong sense of countries' ownership, and has also encouraged a more open dialogue between governments and civil societies, while at the same time respecting the necessary government leadership in the process. Better understanding of the problems, and a more accurate identification of the objectives, are crucial for improving the effort's focus on target groups. Addressing program weaknesses and shortfalls can improve resource allocation and the effectiveness of financial flows. Since the domestic causes of poverty are linked to a broad spectrum of domestic constraints, efforts to coordinate actions of official and civil institutions dealing with poverty alleviation --and between them and the donor community-- are also needed. More often than not reforms in low-income countries are hampered by inadequate capacity rather than lack of political will. It is of utmost importance to strengthen capacity building with continued technical assistance and training activities in the areas of responsibility specifically related to macroeconomic and financial issues. In this area, the experience of successful emerging market economies could prove useful.
The weak export performance of low-income countries lies at the root of their problems. This weakness results from their limited development of export opportunities which force them to concentrate on one or two commodities, and the steady decrease of non-fuel commodity prices prompted by weak global demand. In sectors where they have comparative advantage, their limited access to international markets has stunted their export development. Concessional financing and support by the donor community and the IFIs is therefore indispensable as a safety cushion. Additional HIPC relief is also justified for some countries with good track record of policy implementation that have been pulled down by a worsening external environment; but care must be taken to identify these cases as exceptional to avoid the moral hazard effect that generalized higher flexibility may generate. The Monterrey Consensus is a welcome step forward in dealing with world poverty, and we are confident that the emphasis on the two-pillar approach will soon be put in practice. Sharing responsibilities in a pragmatic way between the poor and the advanced economies is the only way to reach the desired goal of eliminating of poverty and achieving a stable world environment.
Streamlining conditionality and enhancing ownership
Streamlining conditionality and focusing it around measures that are critical for reaching program objectives, and fostering national ownership of Fund-supported programs, are key elements for increasing their success and effectiveness. A case-by-case approach has been used in considering the criticality of structural conditions for achieving the macroeconomic objectives, and provides a practical way forward given the difficulty of agreeing on general criteria. This makes it even more necessary to discuss conditionality thoroughly in relation to the particular circumstances of each program. Consideration of political economy and institutional capacity will be critical for avoiding excessively strenuous or intrusive requirements that could weaken the conditionality's focus and effectiveness.
Member countries do not focus solely on the Fund's conditionality, but on the totality of conditions included in their policy program. Consequently the need for coordination among all the involved institutions is paramount, particularly in the case of more comprehensive programs. Finding the appropriate conditionality mix for crisis countries suffering sudden and massive outflows of private capital presents perhaps the most difficult challenge in terms of striking the right balance between thoroughness and parsimony, and thereby maximizing conditionality's effectiveness. The crisis atmosphere should not be used to justify a bias toward all-inclusive conditionality that would overburden the country's political and technical implementation capacity, and delay the support needed to restore confidence.
While the quest to streamline conditionality may have been generally successful, the results of the exercise must be measured by the willingness of countries to embrace IMF conditionality as their own. The success of the dialogue between staff and the authorities in creating a climate of mutual understanding and trust will always be critical.
3. Combating Money Laundering and the Financing of Terrorism
Money laundering, the financing of terrorism, and other criminal activities that weaken institutions and undermine social cohesion call for a firm and coordinated international response. The Fund has an important role to play here by virtue of its core areas of expertise and its important responsibilities for protecting the integrity of the international financial system. The creation of a uniform assessment methodology for a Report on the Observance of Standard and Codes (ROSC) will be the centerpiece of this process. Using a unified ROSC module entails significant benefits since it can merge the efforts of all organizations working on this task, avoiding duplication, and preserving its voluntary, uniform, and cooperative nature. On the modalities for conducting assessments using the converged methodology, we think special care should be taken in distributing responsibilities. For efficiency's sake, we would prefer for the Fund to use a cooperative but focused approach and concentrate its resources on assessing the legal and regulatory frameworks and providing technical assistance.
It is encouraging that several member countries have reportedly implemented the recommendations made in the context of FSAPs and OFC assessments. We must also persevere towards the objective of covering all jurisdictions having international financial centers. There are vulnerabilities that are yet to be addressed concerning regulatory and supervisory systems, and a need to establish wide-ranging information-sharing cooperation, and build awareness among the membership. We also renew our support for the inclusion of voluntary questionnaires in Article IV consultations, which will significantly help ease the discussion of these issues with country authorities. We wholeheartedly support coordinated action among standard setters and the authorities of member countries aimed at combating the abuse of financial systems for money laundering and the financing of terrorism. The Fund's efforts to build country's institutional strength and improve governance in this area are certain to strongly counter the deep social and economic effects of criminal activities on a global scale. Involvement of the Fund in all aspects of this issue should not be expected, given that many of them lie outside the Fund's expertise and responsibility, in particular law enforcement.
4. On Chile and the Southern Cone Countries
The effects of the global slowdown on external demand, terms of trade and financing, and spillover from the Argentine crisis have created a difficult environment for the countries of this constituency. These difficulties have prompted some of them to seek financial and technical support from the IMF to reestablish the conditions for sustained growth. Last month Uruguay finished negotiating a new stand-by arrangement with a large access to Fund resources intended for replenishing the official liquidity position. The announcement of the arrangement has already had a positive effect on market confidence; and the implementation of the program, which is focused on strengthening the fiscal position, increasing exchange flexibility and deepening the structural reforms, should complete the conditions for recovery and permit Uruguay to reap the benefits of its authorities' determined pursuit of sound policies. Bolivia's recent performance under its PRGF-supported program was also affected by deteriorating external conditions and the adverse effects of the coca eradication program. Lower growth has increased the need for additional borrowing and debt relief.
The confidence of investors in emerging market economies and in the region has failed to improve, or do so only in a very limited fashion, partly because of the Argentinean crisis. Argentina has been cut off from all international and domestic credit, leading to its declaration of default. Under such conditions no country can function normally but will be condemned to a downward growth spiral, increasing the risk of further political and social deterioration. The early restoration of credit and of the payments system is essential for beginning the process of recovery. It would be appropriate for the Fund to take a more active role in seeking a solution to the Argentinean problem and its ramifications.
My own country, Chile, has also been exposed to a severe and prolonged external shock that has depressed its terms of trade, slowed the growth of its export volumes, and reduced net capital inflows. Despite this adverse shock, the macroeconomic performance remains satisfactory with continuous growth (although below potential), low inflation and a sustainable external position. These results are much better than those obtained in the past when Chile was confronted with similar challenges. The difference reflects the benefits of the golden triad of macroeconomic policy: a consolidated fiscal position based on a counter-cyclical policy rule, a credible monetary policy based on inflation targeting conducted by an autonomous central bank, and a floating exchange rate system. The fiscal policy rule of a structural surplus of 1 percent of GDP has played a central role in increasing the resiliency of the economy to the shocks by directly supporting demand and by giving monetary policy increased room to act in a counter cyclical way. The full implementation of the fiscal policy rule in 2001 has strengthened Chile's credibility, as shown by the reduction of the sovereign spread below 100 basis points during the last month. This was not the case in 1999, when spreads were not only higher, but also increased as fiscal policy attempted to act counter cyclically. Inflation targeting has completed its 11th year of continuous success, consolidating the low inflation environment and the credibility of monetary policy. In addition, the main monetary policy signal has been refined and the policy stance is now defined on the basis of a nominal variable, the target for the overnight interbank interest rate in pesos.
The full implementation of the fiscal policy rule, the continuous attainment of the inflation target and the floating exchange rate-- all have built a macroeconomic framework capable of absorbing and managing the external shocks by letting the currency fluctuate while appropriately adjusting interest rates. Chile's external conditions have involved some degree of contagion. In particular, developments in Argentina exerted strong pressures on the Chilean peso, as also on the Brazilian real and other currencies, as capital fled the region. The contractionary effects of these capital outflows cannot be fully compensated because the pass-through of the depreciation to prices sets limits to the aggressive use of monetary policy, and because the depreciation alone had contractionary effects through the balance sheet positions of the private sector. Chile's sound banking system and improvements in the provisions against direct and indirect currency and maturity mismatches in bank portfolios have make banks more resistant to exchange rate and interest rate adjustment, in effect removing some constraints for exchange rate movements and increasing the space for policy actions.
The development of the local capital markets also has also been important to confront the shock, allowing for more intensive use of domestic financing and better management by individual agents of their exposure to market risks. More needs to be done in this regard, particularly in the development of long-term financial instruments denominated in domestic currency. The outstanding debt in foreign currency remains sizeable and the resulting net foreign currency position means that a depreciation would have an adverse wealth effect. Deepening the market for medium- and long-term debt instruments in domestic currency would help to reduce this mismatch and solve the problem. The international financial institutions can be instrumental in producing this outcome.
Looking ahead, Chile is well positioned to resume a trend of higher growth,
driven in the short-term by the improvements in the global conditions
and a local policy mix that is demand supportive. A successful completion
of the free trade agreements being negotiated, including with the European
Union and the United States, also will contribute to the resumption of
rapid growth, and send a positive signal to other developing countries.
In the medium-term, the economy should also reap the gains of the recent
reforms of the domestic capital markets, which should essentially complete
the process of financial integration with the rest of the world and will
increase efficiency in the mobilization of savings and investment.
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