The Global Economy and Financial Markets—Outlook, Risks, and
Policy Responses

After a relatively robust recovery in early 2002, it appears that the growth of the world economy has recently lost some strength. Growth has again begun to weaken in the United States, and remains subdued in the euro area and Japan. The situation has also worsened for some emerging market countries, mostly in Latin America, which are adversely affected by the loss of market confidence, the weaker growth in the industrial countries, and their deteriorating access to international capital markets.

At this juncture, the global economy faces several risks. Higher oil prices would damage growth in many oil-importing countries, particularly emerging market and developing countries. A weaker global recovery could cause equity prices to weaken further, which would worsen credit conditions and undermine consumer and business confidence. The failure of market confidence to improve could further limit the access of emerging market countries to private external financing, and dim their prospects for economic growth.

Despite these short-term risks, global economic activity should strengthen later this year and in 2003. In most of the advanced economies, interest rates have remained low and monetary policy is supporting domestic demand, particularly in the United States. It is also encouraging that most financial institutions around the world have been able to cope well with the adverse shocks they suffered last year.

In the United States, macroeconomic policy remains appropriately stimulative. The large dose of monetary and fiscal stimulus has helped limit the adverse effects on growth of September eleventh, corporate governance failures, collapsing equity prices, and the end of the hi-tech boom, which left behind a large stock of excess capacity.

Unfortunately, this stimulus has yet to return output growth to its potential. With low inflation and large unused capacities, interest rates should be kept low. From the global standpoint, the recent orderly weakening of the dollar is welcome, and should assist the gradual correction of the large current account imbalances. Looking further into the future, it is important to ensure that the fiscal stimulus does not cause a protracted erosion of the fiscal position. A gradual implementation of fiscal consolidation should help preserve a sound fiscal position like that, which assisted the strong growth performance of the U.S. economy in the 1990s, and increase national saving.

The outlook and policy responses in the European Union are well described in the EU Presidency statement. Domestic demand remains weak. Because of weak growth of output and employment, unemployment has unfortunately begun to rise. But inflation has now abated to around 2 percent and, unlike in the United States, there are no significant imbalances. Letting the automatic stabilizers operate according to the rules of the Stability and Growth Pact and making further progress in structural reforms is needed to take better advantage of the new technologies, achieve higher growth and reduce unemployment.

In Japan, there are tentative signs of a recovery, but it remains very fragile and highly dependent on external conditions. Deflation continues to have a negative impact on the economic outlook. The obstacle to a stronger recovery is the unfinished business of structural reforms, and especially the resolution of the bad loans that weigh so heavily on both the financial and nonfinancial sectors. Fiscal policy has reached the limit of its ability to help. Its focus should shift to improving the structure of public spending that assists the restructuring and recapitalization of the financial sector, and helps soften the effects of the accelerated structural reforms on the population. Monetary policy should remain as accommodative as possible.

In several emerging market countries, particularly in Latin America, the situation has become difficult. Despite very strong policies implemented under its Fund-supported program, Brazil suffered a significant loss of market confidence triggered by uncertainties related to the upcoming presidential elections. Under these circumstances it was appropriate for the Fund to provide further financial assistance, against a promise that the new administration will continue and if need be reinforce the present strong policies. I encourage the leaders and people of Argentina to reach the political consensus required to overcome their country's deep crisis with the help of the Fund.

EU Accession countries benefit from the confidence-building effects of their prospective EU membership. Sound policies and progress with implementing the acquis communautaire will help them maintain reasonably strong growth, supported by foreign direct investment and domestic demand.

In spite of the difficult international environment, Turkey continues to implement its Fund-supported program very well, and has made further important and welcome steps toward its EU accession. It is important for the new government that will emerge from the upcoming election to continue the present policies. This should assist a rapid return of market confidence and growth.

Thanks to good macroeconomic policies and favorable external factors, Kazakhstan enjoys high output growth and a strong fiscal and external position. It now has a net external creditor position and an investment grade credit rating for its foreign currency denominated sovereign debt.

Belarus traditionally pursues responsible fiscal policies. Last year it unified its foreign exchange rates and introduced full convertibility for its currency. Financial support from the Fund would make Belarusian policymakers more confident about implementing ambitious structural reforms.

Strengthening Surveillance and Crisis Prevention

Its surveillance mandate distinguishes the Fund from all other IFIs. In the pursuit of this mandate the Fund is a powerful tool for promoting sound policies and good global governance.

Promoting the soundness of countries' financial systems has rightly become a major objective of Fund surveillance. The Financial Sector Assessment Program (FSAP) has been very instrumental to that end. It should become an integral part of the Fund's surveillance.

Correctly assessing the sustainability of a country's external position and public debt is an essential part of surveillance. The new framework for analyzing debt sustainability is most welcome and should be rigorously used. It will also help the Fund make better-informed decisions when providing financial assistance. The Fund should use this kind of analysis not only for countries that have access to international capital markets, but also for the Heavily Indebted Poor Countries (HIPCs) whose debt sustainability remains a challenge.

One of the lessons of the Asian crisis was that surveillance should cover the exposure to exchange and interest rate volatility of the most important sectors: the government, the central bank, the banking sector, the corporate sector, and the household sector. We encourage the Fund to make progress toward that goal.

The Fund can strengthen its surveillance over program countries. Article IV consultations with program countries should be kept sufficiently independent of program design and monitoring.

Transparency now plays a critical role in informing markets and improving their functioning. All the countries of our constituency publish their Article IV reports on a voluntary basis. It has been our experience that publishing these reports encourages the implementation of sound policies. The publication of staff reports also helps ensure that Fund financial support catalyzes other financial flows. More countries should publish their staff reports, for their own good and the good of the international community.

Recent corporate and accounting scandals show that the adequacy of standards and codes for corporate governance, accounting, and auditing should be reviewed and tightened where necessary. The IMF and the Bank should tighten their monitoring of compliance with these standards by all countries, in particular the advanced ones. FSAPs should include Reports on Standards and Codes (ROSC) for corporate governance, accounting and auditing.

Strengthening Crisis Resolution

The Fund should continue to provide exceptional access to countries with strong programs and sustainable debts if this will restore market confidence. There must be a rigorous proof that the program is strong and commensurate with the seriousness of the problems and by comparison with other countries' programs. The chances of success must be good, and efforts must be made to involve the private sector in resolving the crisis. Better documentation of the Fund's decisions in all these areas will improve the transparency, consistency, and predictability of the Fund's role in the resolution of financial crises.

When a country's public debt is not sustainable, it must be restructured. The international community has long recognized that collective action clauses (CACs) in sovereign bond contracts would be useful for easing the restructuring of bonds governed by foreign law. The G-10 is working with market participants' representatives to develop CACs suitable for the main jurisdictions and has started to exchange views with representatives of emerging market economies about such clauses. EU member states will include majority action clauses and collective representation clauses in new government bonds issued under a foreign jurisdiction, in order to promote the use of CACs in international bonds.

The Sovereign Debt Restructuring Mechanism (SDRM), vigorously championed by the Fund's Management, would complement and reinforce the contractual approach to improve crisis resolution. It could be even more effective than contractual CACs because an SDRM helps solve collective action problems connected with all international claims on a sovereign. The Fund should work to broaden the present consensus in the Board on the kinds of sovereign debt to be covered by the SDRM. Other issues to be further examined include the treatment of non-sovereign debt, the role of exchange controls, the relative standing of senior private financing and financing by preferred creditors after a standstill, the protection of creditors' interests during the standstill, and the implications of an SDRM for the HIPC process. The Executive Board should speed up its consideration of these issues wit a view to proposing a draft amendment of the Articles of Agreement establishing the SDRM.

The Role of the IMF in Low-Income Countries

The strategy for reaching the ambitious Millennium Development Goal of halving extreme poverty by 2015 is well known. In the last 12 months it has been endorsed by heads of state at Doha, Monterrey, and Johannesburg. Low-income countries must stop making war, restore democracy and the rule of law, and pursue stability-oriented policies and market-oriented reforms. They should provide all their people with health care and education. The advanced countries must increase the amount and effectiveness of their aid. And both advanced and developing countries must open their markets wider to the exports of the low-income countries.

The Fund has the critical task of promoting the translation of these good intentions into deeds.

First, the Fund must continue assisting the low-income countries in designing and implementing macroeconomic policies that are part of their poverty reduction strategy. More countries should adopt full Poverty Reduction and Strategy Papers (PRSPs). Growth and export assumptions must be realistic. The Fund should always rely on World Bank expertise for the ex ante Poverty and Social Impact Analysis (PSIA) of the measures it recommends. This analysis should be based on statistics and on qualitative information from the poor countries, including representatives of the poorest people who have a first-hand understanding of poverty's causes and cures.

Second, the Fund and the World Bank must continue helping all eligible countries to obtain debt relief under the HIPC Initiative. For good performers that are hit by exogenous shocks, debt relief should be enhanced. Countries emerging from conflicts require flexible treatment. All creditors should contribute to HIPC debt relief

And third, the Fund should use its surveillance as a means of keeping each country focused on its responsibilities in connection with the Millennium Development Goals.

Combating Money Laundering and the Financing of Terrorism

The addition of the 40+8 Recommendations of the Financial Action Task Force (FATF) on money laundering and terrorism financing to the existing list of standard and codes monitored by the Fund and Bank is very welcome. Countries whose compliance with these recommendations has not yet been assessed should request assessment by the Fund or the Bank or undergo a mutual evaluation as a member of FATF or a FATF-Style Regional Body (FSRB).

The cooperative and voluntary nature of the ROSC process cannot be used as an excuse for non-cooperation. Of all the standards whose compliance is being monitored by the Fund and the Bank, the standard on Anti Money Laundering and Combating the Financing of Terrorism (AML/CFT) would suffer most from a country's failure to combat the criminal activities that damage societies and economies. More than others, the AML/CFT standard requires universal participation to be effective. Countries that are unwilling to begin a ROSC assessment within a reasonable time expose themselves to the actions that other countries may take to protect their financial sectors and societies against abuse. But countries that cooperate should receive the technical assistance needed to overcome their deficiencies.