The Global Economy and Financial Markets - Outlook, Risks and Policy Prospects

After a robust start in early 2002, global output growth weakened toward the end of the year. It appears that the lingering effects of the bursting equity bubble, continued excess capacity in certain industries, high oil prices, and the flagging of business and consumer confidence, which were further eroded by geopolitical uncertainties, all contributed to this weakening.

The latest developments, which again awaken concerns about the health of the world economy, specifically challenge us as policymakers. Our most important responsibility is to restore the confidence of firms, investors, and consumers, and take all the measures needed for generating a robust and sustainable recovery.

Before getting into detailed policy recommendations, I want to emphasize one important policy message. In the current situation of increasing political fragmentation, we must make a great effort to preserve the present international cooperation in economic and financial matters. In addition to a maximum effort to keep the negotiations of the Doha round going, we must increase our efforts to pursue policies that will help stimulate the economic growth of each individual country while preserving the medium term prospects. The international financial institutions must also be ready to provide temporary financial assistance to these countries that are being damaged by the present difficult environment are committed to sound policies, but do not have room to deal with shocks without undue hardship for their people.

By virtue of its large weight in the world economy, the economic performance of the United States always plays an important role on the world stage. It is therefore reassuring that in spite of the serious shocks imparted to the U.S. economy by terrorist attacks and the collapse of the equity bubble, U.S. productivity growth is being kept strong by a continued underlying vigor that bodes well for future growth. Monetary and fiscal policies continue their strong support to economic growth, and the corporate scandals that have dented investors' confidence have been met with strong regulatory and other measures.

We must also be mindful of what underlies the strong performance of the U.S. economy and makes it resistant to adverse shocks. One of the most important factors was the prudent fiscal policy of the 1990s, which dramatically improved the public finances. It is important to preserve this gain. For this reason the recent active use of fiscal policy to stimulate the economy and increase its efficiency should be accompanied by an unequivocal (and credible) commitment to continued fiscal prudence. Prudent fiscal policies in the United States would also lead to a more orderly adjustment of today's worrisomely large current account imbalances.

Unfortunately, growth in Europe remains much weaker than in the United States. The Euro area is growing slower than its potential, with output in Germany close to stagnation, partly due to prevailing macroeconomic and structural conditions and partly due to weak global growth. With some Euro area members finding it hard but remaining committed to observe the fiscal targets of the Stability and Growth Pact, fiscal policy cannot, beyond the appropriate use of automatic stabilizers, provide the support to economic activity that would otherwise be called for. This is the price that must be paid for relaxing fiscal policy too much in periods of high growth. A stability-oriented medium-term fiscal path is also necessary to maintain the credibility and sustainability of the Euro area's fiscal policy, especially in view of the ageing challenges ahead.

The current level of the euro, following its strengthening, better reflects economic fundamentals. It also helps reducing inflation, thereby strengthening domestic demand in the euro-area.

The combination of weak growth, scant room for fiscal policy, currency appreciation, and abating inflationary pressures could create the conditions for a further easing of monetary policy, once the geopolitical uncertainty has lessened and economic prospects become clearer.

Monetary policy by itself cannot bring about a restoration of sustained robust growth in Europe. The analysis in the latest World Economic Outlook illustrates the benefit, in terms of higher employment and growth, that would flow from more ambitious reform of Europe's labor, product and capital markets. This analysis underpins the present EU strategy in the field of structural reforms. In this connection, several European countries have taken initiatives to make their labor market more flexible, and increase the employment rate, especially for older workers.

Japan's growth remained very weak last year despite some growth of exports, and it is not expected that it will gain much strength this year either. Most worrisome are the persistence of deflation and the increasing entrenchment of deflationary expectations. Thus, the Bank of Japan must not only continue its aggressive pursuit of a policy of quantitative easing, but must also step up its efforts to remedy the failures in the transmission mechanism and thereby reduce the public's deflationary expectations. The continued weakness of economic activity and the decline in equity prices have created a precarious situation for Japanese banks that calls for urgent action. The authorities must make sure that the banks acknowledge all their nonperforming loans, and provide any public financial assistance needed to strengthen their capital and head off more systemic problems. Neither monetary nor exchange rate policies should be seen as a substitute for the long overdue structural reforms in the financial and corporate sectors.

The persistent weakness of global economic activity and the increase in investors' risk aversion have created a difficult environment for the emerging market economies. In this context, it should be noted that credit markets appear to increasingly differentiate among potential borrowers, so that countries with strong policies and relatively low levels of external debt enjoy continued access to the international markets at reasonable conditions. Recent advances in Brazil are especially encouraging, and set a good example for other countries to follow. The firm commitment of Brazil's new government to continue the stability-oriented policies of the previous government, together with increased attention to social issues and structural reforms, have generated a positive response in the financial markets. By showing that the financial markets are still able to reward good behavior, Brazil's example should encourage other emerging market countries to pursue similar good policies.

Turkey's firm commitment to pursue sound economic policies under the IMF-supported program has preserved a generally positive market reaction. Additional financial support will greatly help Turkey to overcome the economic effects of the war in Iraq. Turkey will continue to meet the conditions of its IMF stand-by arrangement so that market confidence will be strengthened further.

At the Copenhagen Summit of December 2002, a historic event took place, with the acceptance of 10 new members for EU accession in May 2004. The EU candidates are already reaping benefits from their future EU accession. The financial markets have reacted positively to expectations that the accession process go smoothly, and unlike some other emerging market countries, these EU candidates were little affected by adverse developments in the international capital markets. It is important for candidates to complete the policy adjustments needed to foster real convergence and thereby creating the conditions for entering the Economic and Monetary Union. In a number of countries this will require bringing their present large fiscal deficits into line with the requirements of the Maastricht Treaty. And while most EU candidates have significantly reduced their inflation, it now becomes essential for them to keep it that way. It should also be emphasized that effective cooperation of the authorities responsible for monetary, fiscal, and other policies is essential to ensure that the processes of EU and EMU accession proceed smoothly, with a minimum of market turbulence.

Thanks to good macroeconomic policies and high oil prices, Kazakhstan enjoys high growth and strong fiscal and external positions. Kazakhstan is bolstering its long-term financial strength and protecting its economy against oil price volatility by saving a considerable amount of its oil revenues in its National Fund.

Belarus continues to pursue responsible fiscal policies. Last year, it successfully privatized large public enterprises, and attracted significant amounts of foreign investment. Financial support from the Fund would make Belarusian policy makers more confident about implementing ambitious structural reforms.

Many of the world's poorest countries have been especially hard hit by the latest global developments. Higher oil prices have increased their imports, while weak global activity continues to hold down the world prices of some of the commodities they export. During this difficult time, it is important for the international community, at the level of both institutions and individual advanced countries, to increase their support. The IFIs should be ready to provide temporary financial assistance quickly where it is needed and where its effective use is ensured by sound policies and policy frameworks. We in the industrial countries should continue our efforts to open our markets to the exports of the poorer countries, so that they, too, can fully benefit from their participation in the global economy.

Strengthening Crisis Prevention

The IMF must continue improving data dissemination, sharpen financial sector surveillance, spot external vulnerabilities, promote best practices, assess the sustainability of public and external debt, make the Fund's policy advice more transparent, and strengthen its surveillance of program countries.

Examining the soundness of financial sectors is part and parcel of the IMF's Article IV surveillance mandate. I strongly encourage countries, not yet participating in the World Bank and IMF-led Financial Sector Assessment Program (FSAP) to do so. FSAP should be conducted in a cost-efficient manner.

Reports on the Observance of Standards and Codes (ROSCs) should be made not only on countries and areas most needing improvement, but also on countries that are implementing best practices. This will both help the Fund keep abreast advances in these practices, and avoid negative signaling. The ROSCs for the less advanced countries should examine those norms that are relevant given the country's stage of economic development and its progress towards compliance.

Only when policies are transparent can a market economy function well. In the last five years the movement toward voluntary publication of country documents has greatly increased the transparency of the Fund's activities in most parts of the world. When it again reviews its publication policy, the Fund must ensure that this momentum towards increased transparency is not lost.

The Fund's surveillance must include values-at-risk in the balance sheets of the most important sectors, namely the government and central bank and the banking, corporate, and household sectors. Surveillance should also aim at predicting the likely consequences for its neighbors of a country's external weaknesses. More cross-country analyses could detect such weaknesses and produce better recommendations for their correction based on experience elsewhere.

The Fund's policy recommendations to countries must remain evenhanded. Fund surveillance must help countries forge political consensus for adjustment and reform by clearly presenting their merits.

Improving the Ability to Resolve Financial Crises

We should actively pursue our two-track approach to improve our ability to resolve financial crises: the introduction of Collective Action Clauses in sovereign bond contracts and the adoption of a Sovereign Debt Restructuring Mechanism.

Collective Action Clauses

I welcome the significant progress achieved in this field. The Fund should endorse the G-10's framework on Collective Action Clauses (CACs) aimed at easing the orderly restructuring of an unsustainable sovereign debt. The Fund should promote these CACs through its bilateral and multilateral surveillance. The IMF and World Bank guidelines on public debt management should recommend including these CACs in external bond issues.

Sovereign Debt Restructuring Mechanism

I am grateful for the Fund's excellent work on concrete proposals for a Sovereign Debt Restructuring Mechanism (SDRM). Just as orderly insolvency procedures are indispensable for a market economy, so is an orderly mechanism for restructuring sovereign external debt essential for the proper functioning of the international financial system.

When faced with unsustainable external debt, a sovereign debtor should be able to seek protection and obtain a temporary standstill on payments to, and stay of litigation by, its creditors, after an independent, impartial international authority has confirmed that the debt is unsustainable. This would contribute to preserving inter-creditor equity. The latest Fund proposals do not go that far, but they have significant merits:

1) the SDRM would apply to existing debt contracts, and would therefore overcome the problem posed by the large stock of existing bonds that do not include collective action clauses;

2) the SDRM would allow the aggregation of debt across different instruments, which CACs do not permit;

3) the SDRM would enable private creditors to grant new credit to a country in crisis on a preferred repayment basis; and

4) an amendment of the Article of Agreement to establish the SDRM would provide an explicit legal basis for the Fund's preferred creditor status.

Several issues are still unresolved, including the activation modalities, and the scope and identification of claims. The IMF should continue its work on the SDRM and keep the IMFC up to date on its progress.

Code of Good Conduct

The IMF should help establish a Code of Good Conduct for resolving collective action problems that arise among holders of international sovereign bonds. This code should outline the public policy aims of a statutory SDRM and of contractual CACs defining collective action by creditors. Such a code is no substitute for the introduction of CACs or the adoption of the SDRM. Strong ownership of the code by debtors and creditors is key to its effectiveness.

Implementing Initiatives to Support Low-Income Countries

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

The Fund has the critical task of helping to translate these good intentions into deeds.

First, the Fund must continue helping the low-income countries to design and implement macroeconomic policies that advance their poverty reduction strategies. More countries should adopt full Poverty Reduction and Strategy Papers (PRSPs). Parliaments, trade unions, business organizations, and civil society organizations should contribute to the PRSP. Growth and export assumptions must be ambitious but realistic. Control of public revenues and expenditures must be strengthened. The Fund, assisted by the World Bank, should make an ex ante Poverty and Social Impact Analysis (PSIA) of the measures it recommends for inclusion in the programs supported by the Poverty Reduction and Growth Facility (PRGF). The PSIA should be based on statistical and other information from the country itself, including input from the poorest classes, 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 obtain debt relief under the HIPC Initiative. For good performers hit by exogenous shocks, debt relief should be increased at the completion point. Countries emerging from conflict 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 own responsibilities in the effort to reach the Millennium Development Goals.

The Fund should continue to enhance the participation of all developing countries and countries with economies in transition in its decision making process. I support an increase in the staffing of the largest multi-country constituencies, an increase of the number of basic votes, and an improvement of technological support and administrative capacity at country and regional level.

Combating Money Laundering and the Financing of Terrorism

We welcome the addition to the existing list of standards and codes monitored by the Fund and the World Bank, of the 40+8 Recommendations of the Financial Action Task Force (FATF) on money laundering and terrorism financing. Countries whose compliance with the FATF recommendations has not yet been examined should request assessment by the Fund or the World Bank, or undergo a mutual evaluation as a member of FATF or a FATF-Style Regional Body. The Fund, the World Bank, FATF, and FATF-Style Regional Bodies should coordinate to avoid duplicated assessments and achieve a fair division of labor.

The cooperative and voluntary nature of the ROSC process cannot be used as an excuse for non-cooperation. More than the others, the standard on Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) requires universal participation to be effective. Countries should receive the technical assistance needed to overcome any deficiencies found.