Speech

Globalization Challenges for the IMF -- Remarks by Mr. Takatoshi Kato, Deputy Managing Director, International Monetary Fund

March 13, 2006

It is a pleasure to be here with you to join the 75^th anniversary event of the Woodrow Wilson School. Today, I will talk about the opportunities and challenges of globalization, seen from the vantage point of the International Monetary Fund. I will start with a brief overview of recent global economic developments. Then, I will examine risks and challenges, with a particular focus on the implications for emerging market economies and low-income countries, and how the IMF can help countries respond to these challenges, with a particular focus on our role in low-income countries.

Global economic performance has been positive over the last couple of years. World output growth in 2004 was the highest in three decades, at over 5 percent, and it remained strong in 2005, despite higher oil prices. The expansion has become more broadly based, and the increase in global growth has occurred without a significant pickup in inflation. International financial market conditions have been favorable for quite some time, with unusually low risk premia and volatility.

This benign international setting has been favorable for developing countries, and especially for emerging market economies. More stable macroeconomic conditions and higher growth also reflect better economic management in many of these countries. Reforms have been initiated that cover a broad range of policies and public institutions. Many of these reforms are in line with IMF analysis and policy advice, including through our programs to set up and monitor benchmarks for the financial sector - what we call the Reports on the Observance of Standards and Codes (ROSCs) and Financial Sector Assessment Programs (FSAPs).

In many low-income countries, the situation has also improved and growth has picked up as well, although less markedly. These countries have undertaken to write their own Poverty Reduction Strategies. This process has been useful in promoting country ownership of a comprehensive development strategy and making poverty reduction more prominent in policy debates. Many low-income countries now have more fiscal room to accelerate progress towards the Millennium Development Goals (MDGs), owing to higher donor assistance, as well as debt relief, including through the various debt relief initiatives over the last 10 years. Most recently, the Fund gave 100 percent debt relief to 19 poor countries.

All this is good news. Yet, it would be unwise and premature to claim victory either in ridding the world of economic ills or of poverty. So I would like to talk about overall global risks and vulnerabilities. And then take a closer look at the situation of low-income countries, which have been falling behind in their development progress, and at the role that the IMF can play in assisting them.

Regarding risks and vulnerabilities, the IMF sees the widening global imbalances as a substantial risk to global growth. The current equilibrium is unstable, as it rests on the capacity of the United States to continue to attract foreign savings. Foreign investors may become unwilling to hold increasing amounts of U.S. financial assets and demand higher interest rates, especially if Asian countries recover from the investment drought that they have experienced since the Asian crisis. A depreciation of the U.S. dollar may be necessary to induce U.S. domestic demand to contract. However, if this or other adjustments occur abruptly, it could cause a slowdown in demand and output, as well as financial market disruptions, at the global level.

Therefore, the IMF has underscored the urgent need to use the current favorable environment to address vulnerabilities arising from growing imbalances. It has repeatedly called for coordinated multilateral policy actions to help bring about a gradual and orderly unwinding of those imbalances—unfortunately, there has been at best a limited progress to date. Action is needed in all the main blocs, including (i) tighter fiscal policy in the U.S.; (ii) greater exchange rate flexibility in Asia; and (iii) structural reforms to improve productivity and medium-term fiscal sustainability in Europe and Japan. High and volatile oil prices are likely to complicate the adjustment, so IMF advice has focused on the appropriate policy response.

Crisis prevention also implies actions in emerging market economies, which have benefited the most from the increased trade and investment flows brought about by globalization, but which are also most at risk of a reversal of capital flows. With a view to increase their resilience to external shocks, the IMF is working with these countries to analyze the consistency and sustainability of macroeconomic policies, debt dynamics, and exchange rate regimes, and improve policy and debt management.

To be effective in crisis prevention, the IMF must adapt its operations, particularly its surveillance of the global economy, to the challenges of globalization and innovation in financial and capital markets. The IMF intends to place financial sector issues at the heart of its surveillance work and give also greater prominence to exchange rate issues.

Another aspect of the IMF's work in emerging markets is crisis resolution, including through the provision, in rare cases, of exceptionally large IMF financing to deal with capital account crises. One result of this work has been the additional impetus given to initiatives such as collective action clauses and principles for voluntary debt restructuring. But the financial assistance available from the IMF is small compared to the scale of capital flows in emerging markets. The perceived inadequacy of reliable insurance against financial catastrophes has prompted many countries to self-insure through massive and often costly buildup of reserves. The IMF is exploring options for addressing these countries' legitimate concerns, including the possible introduction of high-access precautionary arrangements.

Let me now turn to the issue of low-income countries. This is one area to which the IMF dedicates substantial human resources at its disposal. In fact, 78 of the 184 IMF members are low-income countries. Low-income countries have for the most part been unable to reap the full benefits of globalization. Notwithstanding recent improvements in some countries, growth is still too low to make substantial progress towards the MDGs, especially in Sub-Saharan Africa. Yet, some countries have started paying greater attention to the issue of accelerating growth in their poverty reduction strategies.

One area where more can be done is trade. The successful conclusion of the Doha Round remains a priority for promoting growth and poverty reduction, and the IMF has consistently called on industrial countries to improve market access for developing countries' exports and eliminate distorting subsidies, especially in agriculture. But some countries might require assistance to enhance their ability to participate in global trade, so called "aid for trade." The IMF supports these countries through what we call the Trade Integration Mechanism, which gives financial assistance to help them cope with the possible balance of payments impact of liberalization by trading partners. Bangladesh is the first user of this facility and we can identify a couple of potential users among countries in Sub-Saharan Africa. We also provide analysis and policy dialogue on trade-related issues; technical assistance for customs administration, and participate in the Integrated Framework for Trade-Related Technical Assistance.

There are now firm indications that promises for scaling-up aid will be kept. Together with debt relief, many countries face favorable prospects for a substantial increase in the volumes of development finance. Thus, it is most important to take steps now to ensure that aid is used effectively. But this is not a trivial matter: too often in the past, development financing has failed to promote sustainable growth and poverty reduction. The IMF supports international efforts to improve aid effectiveness through better alignment of assistance with national poverty reduction strategies, improved donor coordination, and harmonization of aid modalities and processes across donors, as set out in last year's Paris Declaration on Aid Effectiveness. Signals from the IMF on the stance of a country's macroeconomic policy and prospects are an important input in donors' decisions to scale-up aid. In addition to program arrangements under the PRGF, the Policy Support Instrument of the IMF provides a mechanism to monitor and endorse the policies for members which do not need, or do not desire, the Fund's financial assistance. In fact, Nigeria and Uganda chose to employ such PSI framework to date. With the World Bank, the IMF also has a role in monitoring the use of resources freed up by debt relief for priority spending, especially in health and education.

Most importantly, the IMF can play a fundamental role in helping low-income countries address the macroeconomic challenges inherent in the development process, including those arising from scaling up aid flows. I wish to highlight three challenges we are helping our low-income member countries face:

The first is what we call debt sustainability: the question is how to provide adequate financial assistance to help poor countries meet the MDGs without creating future debt problems. Clearly, the more the world community gives grants rather than loans, the easier this will be. But the hard truth is that there will not be sufficient grants, so countries will have to borrow, even those that have just received debt forgiveness. With this in mind, the IMF and the World Bank have developed an operational framework to assess countries' ability to take on new debt in a way that ensures they do not become overburdened with debt service in the future. But these are very difficult judgments to make in the face of uncertainty about the effective use of aid and the potential growth path of each country. The economics profession needs to continue to do considerably more research if we are to understand how to lend responsibly for development.

Closely related is a second major focus of the Fund—public financial management and fiscal sustainability: increased reliance on aid can expose a country's budget to more volatility and unpredictability, thus complicating budget management, especially if weak revenue collection limits government's capacity to substitute domestic resources in the event of aid shortfalls. Higher aid flows may also exacerbate weaknesses in public financial management systems, limiting the country's ability to utilize additional aid inflows effectively and efficiently. And higher foreign financing may reduce incentives for domestic resource mobilization and fighting corruption. Hence, the IMF has increasingly emphasized fiscal sustainability and governance in its policy advice and financial support. The IMF's guidance and support for low-income countries' institutional building is critical, including through prioritized guidance and tailored technical assistance and increasingly, through the work of its regional technical assistance centers.

Finally there is the issue of competitiveness: large aid inflows could cause a real exchange rate appreciation that may hamper competitiveness and long-term growth; what economists call "Dutch disease." The IMF is helping aid recipients to assess the macroeconomic implications of higher aid inflows, and advising them on policies that facilitate aid absorption, preserve macroeconomic stability and alleviate structural bottlenecks to unleash growth potential.

Low-income countries are also particularly vulnerable to exogenous shocks which can often adversely affect or even derail macroeconomic stability, competitiveness and growth. To mitigate this impact, the IMF provides financial assistance to countries suffering balance of payments needs as a result of an exogenous shock; we have recently established a new lending window, called the Exogenous Shocks Facility, for just this purpose.

Most importantly, perhaps, the IMF is undertaking a medium-term strategic review of its role in the international monetary system, which is changing rapidly as a result of globalization. Our aim is to equip ourselves to deal effectively with the new challenges that the global economy faces. My hope is that the IMF will succeed in serving all its member countries with instruments and advice tailored to the particular circumstances that each faces, so that they may all benefit fully from globalization.