Chapter

CHAPTER 1 IMF Surveillance in Action

Author(s):
International Monetary Fund
Published Date:
September 2003
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The IMF’s Articles of Agreement call for it to oversee the international monetary system in order to ensure its effective operation, and to exercise firm “surveillance”—that is, oversight, including monitoring and analysis—over its member countries’ exchange rate policies. As decided by the Executive Board, this appraisal of a country’s exchange rate policies must involve a comprehensive analysis of the economic situation and policies of the country, including domestic as well as external policies.

The IMF exercises this responsibility of surveillance—over the system and over individual countries’ policies—in several ways:

  • Country (or “Bilateral”) Surveillance. As mandated by Article IV of the IMF’s Articles of Agreement, the Executive Board holds regular consultations with each of its members on the country’s economic and financial policies, including their international repercussions. These “Article IV” consultations, based on staff reports, are known as bilateral or country surveillance. Through this surveillance, the IMF can identify policy weaknesses, signal dangers on the horizon, and advise countries on corrective policy actions. The consultations are complemented by continuous monitoring and analysis of economic and financial developments by IMF staff, informal contacts between staff and national authorities, and informal interim Board discussions as needed.
  • Global (or “Multilateral”) Surveillance. The IMF’s Executive Board regularly reviews major global economic and financial market developments. The reviews are based partly on the World Economic Outlook reports, prepared by IMF staff usually twice a year, and on the Global Financial Stability Report, also prepared twice a year, on the health of the world’s financial system. In addition the Board holds frequent, informal discussions about world economic and financial market developments, and all Directors and staff receive a daily report covering key financial developments in mature and emerging markets.
  • Regional Surveillance. To supplement country consultations, the IMF also examines policies pursued under regional arrangements. It holds regular discussions with such regional economic institutions as the European Union, the European Central Bank, the West African Economic and Monetary Union, the Central African Economic and Monetary Community, and the Eastern Caribbean Currency Union. IMF management and staff also take part in policy discussions of finance ministers, central bank governors, and other officials in such country groups as the Group of Seven major industrial countries, the Group of 24, the Asia-Pacific Economic Cooperation forum, the New Partnership for Africa’s Development, the Gulf Cooperation Council countries, and the Maghreb countries associated with the European Union.
  • The IMF’s approach to surveillance has evolved to keep pace with new challenges. For a comprehensive discussion of steps taken to strengthen IMF’s surveillance, see Chapter 2.

Country Surveillance

To conduct country surveillance in accordance with Article IV, an IMF staff team visits the member country to meet government and central bank officials, and collect economic and financial information. The consultations cover recent economic developments and the monetary, fiscal, and relevant structural policies the country is pursuing. The Executive Director for the member country usually participates as an observer. The team generally also meets other groups—such as trade unions, employer associations, academics, legislative bodies, and financial market participants. The IMF staff team normally prepares a concluding statement, or memorandum, summarizing the findings and policy advice of the staff team, and leaves this statement with the national authorities, who have the option of publishing it.

On their return to headquarters, IMF staff members prepare a report describing the economic situation in the country and the nature of the policy discussions with the national authorities, and evaluating the country’s policies. The Executive Board then discusses the report. The views of the country’s authorities arc con veyed to the Board by the country’s Executive Director. The views expressed by Executive Directors during the meeting are summarized by the Chair or Acting Chair of the Board, and a written summing up is produced. Subject to the approval of the member country concerned, the full Article IV consultation report and a Public Information Notice (PIN), containing a summary of the Board discussion and background material, are released to the public. The country authorities may authorize release of a PIN even if they do not wish to release the full report. In FY2003 the Board conducted 136 Article IV consultations with member countries (see Table 1.1). All PINs and the Article IV reports that the authorities have agreed to release are published on the IMF website.

Table 1.1Article IV Consultations Concluded in FY2003
Country NameBoard DatePIN IssuedStaff Report Published
AlbaniaFebruary 26, 2003March 7, 2003March 7, 2003
AlgeriaFebruary 24, 2003March 5, 2003March 12, 2003
ArgentinaJanuary’ 8, 2003JulY 25, 2003July 25, 2003
ArmeniaSeptember 25, 2002October 9, 2002October 17, 2002
ArubaFebruary 24, 2003March 3, 2003March 3, 2003
AustraliaSeptember 16, 2002September 18, 2002September 18, 2002
AustriaAugust 8, 2002August 14, 2002August 14, 2002
BahrainMay 31, 2002
BarbadosFebruary 7, 2003February 21, 2003March 5, 2003
BelarusApril 16, 2003April 30, 2003April 30, 2003
BelgiumFebruary 21, 2003March 4, 2003March 4, 2003
BelizeNovember 1, 2002November 14, 2002November 22, 2002
BeninJuly 15, 2002August 5, 2002August 5, 2002
BhutanFebruary 21, 2003March 31, 2003
BotswanaOctober 9, 2002November 1, 2002November 5, 2002
BrazilMarch 14, 2003March 24, 2003
Brunei DarussalamApril 30, 2003
BulgariaJuly 22, 2002August 5, 2002August 7, 2002
BurundiOctober 9, 2002October 30, 2002November 6, 2002
CambodiaFebruary 20, 2003February 28, 2003March 6, 2003
CameroonSeptember 18, 2002December 24, 2002November 22, 2002
CanadaJanuary 31, 2003February 25, 2003February 25, 2003
Cape VerdeDecember 16, 2002June 13, 2003June 13, 2003
ChileJuly 19, 2002July 31, 2002July 31, 2002
ChinaAugust 5, 2002September 3, 2002
ColombiaJanuary 15, 2003January 23, 2003January 24, 2003
ComorosOctober 30, 2002
Congo, Dem. Rep. ofMarch 24, 2003April 16, 2003June 16, 2003
Costa RicaMarch 3, 2003March 7, 2003March 21, 2003
CroatiaAugust 5, 2002August 8, 2002August 12, 2002
CyprusJanuary 31, 2003February 14, 2003February 14, 2003
Czech RepublicJuly 26, 2002August 7, 2002August 7, 2002
DenmarkMay 8, 2002May 21, 2002May 21, 2002
DominicaAugust 28, 2002October 9, 2002October 10, 2002
Dominican RepublicJune 7, 2002June 26, 2002
EcuadorMarch 21, 2003April 7, 2003April 7, 2003
EgyptNovember 13, 2002
El SalvadorJuly 19, 2002
EstoniaJuly 1, 2002July 3, 2002July 3, 2002
EthiopiaSeptember 23, 2002October 3, 2002October 7, 2002
FijiAugust 9, 2002September 12, 2002January 8, 2003
FinlandAugust 13, 2002August 15, 2002August 15, 2002
FranceOctober 28, 2002November 13, 2002November 13, 2002
Gambia, TheJuly 10, 2002October 8, 2002
GermanyOctober 23, 2002October 31, 2002October 31, 2002
GrenadaJanuary 27, 2003February 4, 2003February 10, 2003
GuatemalaOctober 2, 2002
GuineaJuly 24, 2002
Guinea-BissauJune 26, 2002July 26, 2002July 26, 2002
GuyanaSeptember 13, 2002
HaitiJanuary 24, 2003March 3, 2003
Hong Kong SARMay 1, 2002May 15, 2002May 15, 2002
HungaryMay 22, 2002June 5, 2002June 5, 2002
IcelandJune 21, 2002July 3, 2002July 3, 2002
IndiaJune 28, 2002August 29, 2002
Iran, Islamic Rep. ofSeptember 18, 2002September 26, 2002September 27, 2002
IrelandJuly 31, 2002August 7, 2002August 7, 2002
IsraelMarch 7, 2003March 13, 2003March 17, 2003
ItalyOctober 21, 2002October 25, 2002October 25, 2002
JamaicaAugust 7, 2002September 11, 2002September 11, 2002
JapanIuK-24, 2002August 8, 2002August 8, 2002
KoreaMarch 3, 2003March 6, 2003March 19, 2003
KuwaitDecember 13, 2002January 2, 2003January 21, 2003
Kyrgyz RepublicFebruary 20, 2003March 7, 2003March 7, 2003
Lao People’s Dem. Rep.August 26, 2002October 4, 2002October 7, 2002
LatviaApril 23, 2003April 28, 2003April 28, 2003
LebanonFebruary 28, 2003March 20, 2003
LiberiaMarch 5, 2003
LibyaMay 6, 2002
LuxembourgJune 5, 2002June 17, 2002June 17, 2002
Macedonia, FYRApril 30, 2003May 20, 2003May 20, 2003
MadagascarDecember 23, 2002January 9, 2003January 9, 2003
MalawiAugust 5, 2002August 16, 2002August 16, 2002
MalaysiaOctober 16, 2002December 10, 2002
MaldivesJanuary 8, 2003February 19, 2003
MauritaniaJune 7, 2002October 11, 2002December 4, 2002
MauritiusMay 24, 2002July 15, 2002July 15, 2002
MexicoSeptember 23, 2002September 26, 2002October 30, 2002
MicronesiaJanuary 24, 2003February 10, 2003February 10, 2003
MoldovaJuly 10, 2002August 26, 2002August 26, 2002
MongoliaOctober 25, 2002November 14, 2002November 14, 2002
MoroccoApril 28, 2003May 9, 2003May 28, 2003
MozambiqueJune 17, 2002July 9, 2002July 9, 2002
MyanmarOctober 23, 2002
NamibiaApril 23, 2003
NepalSeptember 4, 2002September 12, 2002September 24, 2002
NetherlandsJune 10, 2002June 19, 2002June 19, 2002
New ZealandApril 30, 2003May 2, 2003May 2, 2003
NicaraguaDecember 4, 2002December 12, 2002February 10, 2003
NigeriaDecember 18, 2002January 2, 2003January 3, 2003
NorwayMarch 7, 2003March 18, 2003March 18, 2003
OmanOctober 2, 2002November 6, 2002
PakistanNovember 1,2002November 6, 2002November 11,2002
PanamaJuly 10, 2002July 18, 2002
Tapua New GuineaJune 5, 2002
ParaguayMarch 10, 2003March 27, 2003April 8, 2003
PeruDecember 13, 2002December 23, 2002March 14, 2003
PhilippinesSeptember 25, 2002November 14, 2002
PolandJune 7, 2002June 26, 2002June 26, 2002
PortugalMarch 26, 2003April 9, 2003April 9, 2003
QatarJune 24, 2002September 10, 2002
Ro maniaJanuary 8, 2003January 17, 2003January 17, 2003
RwandaJuly 24, 2002September 20, 2002September 25, 2002
St. Kirts and NevisJune 7, 2002June 14, 2002
St. LuciaJanuary 27, 2003May 9, 2003May 23, 2003
St, Vincent and the GrenadinesJanuary- 27, 2003February 14, 2003February 14, 2003
Saudi ArabiaOctober 9, 2002October 25, 2002
SenegalApril 28, 2003June 19, 2003June 19, 2003
Serbia and Montenegro1May 13, 2002May 23, 2002May 23, 2002
SeychellesJuly 31, 2002
SingaporeDecember 9, 2002January 6, 2003
Slovak RepublicAugust 9, 2002August 13, 2002September 26, 2002
SloveniaApril 16, 2003April 25, 2003April 25, 2003
Solomon IslandsJanuary 24, 2003
South AfricaJuly 1, 2002July 19, 2002January 23, 2003
SpainFebruary 10, 2003February 26, 2003February 28, 2003
Sri LankaSeptember 3, 2002September 11, 2002September 13, 2002
SurinamcOctober 16, 2002November 1, 2002
SwazilandDecember 19, 2002December 23, 2002January 31, 2003
SwedenJuly 31, 2002August 7, 2002August 7, 2002
SwitzerlandMay 29, 2002June 3, 2002June 3, 2002
Syrian Arab RepublicFebruary 24, 2003
TajikistanDecember 11, 2002January 3, 2003January 15, 2003
TanzaniaNovember 18, 2002January 6, 2003January 6, 2003
ThailandAugust 2, 2002August 29, 2002
TogoMay 17, 2002
TongaFebruary 5, 2003February 24, 2003February 27, 2003
TunisiaJune 5, 2002June 19, 2002June 19, 2002
UgandaFebruary 12, 2003March 20, 2003March 26, 2003
United Arab EmiratesFebruary’ 12, 2003March 11, 2003March 12, 2003
United KingdomFebruary 26, 2003March 3, 2003March 3, 2003
United StatesJuly 29, 2002August 5, 2002August 5, 2002
VanuatuNovember 22, 2002December 11, 2002December 11, 2002
VenezuelaSeptember 11, 2002
Yemen, Republic ofJuly 31, 2002August 12, 2002
ZambiaNovember 27, 2002
1 Effective February 4, 2003, the Federal Republic of Yugoslavia changed its name to Serbia and Montenegro.
1 Effective February 4, 2003, the Federal Republic of Yugoslavia changed its name to Serbia and Montenegro.

In addition, the Board assesses economic conditions and policies of member countries borrowing from the IMF in the context of its discussions on the lending arrangements that support the member countries’ economic programs.

Global Surveillance

The Executive Board’s conduct of global surveillance relies heavily on two staff reports—the World Economic Outlook and the Global Financial Stability Report—as well as on regular sessions on world economic and market developments.

World Economic Outlook

The World Economic Outlook reports offer a comprehensive analysis of prospects and policies for the world economy, individual countries, and regions. They also examine topical issues. These reports are prepared by the staff and discussed by the Executive Board usually twice a year (and later published), but they may be produced and discussed more frequently if rapid changes in world economic conditions warrant.

In FY2003, the Board discussed the World Economic Outlook on two occasions—in September 2002 and in March 2003. (See Box 1.1 for a chronology of key economic developments during FY2003.)

World Economic Outlook: September 2002 Session

At its September 2002 meeting, the Executive Board noted that economic and financial market developments had been mixed since the spring. Negative developments had occurred on several fronts, Directors noted, including the sharp decline in global equity markets since the end of March 2002; the deterioration in financing conditions facing most emerging market borrowers—notably in Latin America; and weaknesses in a number of current and forward-looking indicators for the United States, Europe, and several other regions. These developments were especially disappointing in light of the strengthening of several global economic indicators, including trade and industrial production, seen since the end of 2001, as well as first-quarter growth that exceeded expectations in several regions.

The world economy and financial market activity had shown considerable resilience in the face of multiple shocks, Directors observed, and, going forward, several factors should support a steady strengthening in global growth—including the continuing stimulus from earlier macroeconomic easing in many regions, the winding down of inventory corrections, and the recent signs of greater stability returning to global financial markets. Nonetheless, Directors expressed concern about the strength and sustainability of the recovery and agreed that the outlook for the remainder of 2002 and for 2003 was likely to be weaker than had been anticipated in the April World Economic Outlook.

The risks to the short-term outlook, the Board assessed, were predominantly on the downside. In particular, Directors noted that equity price falls could have a more marked impact on domestic demand than expected—especially in the United States, which had led the global recovery. Movements in major exchange rates would be appropriate from a medium-term perspective, they observed, although in the short term some negative impact on the recovery in Japan and the euro area, which had been led by external demand, should not be ruled out. Many Directors also saw the persistently high U.S. current account deficit and the still high U.S. dollar value as posing some risk of an abrupt and disruptive adjustment. In addition, tight emerging market financing conditions could further weaken growth prospects and increase vulnerabilities in a number of countries. Directors also noted the potential for further volatility in oil prices in the event of a deterioration in the security situation in the Middle East.

World Economic Outlook: March 2003 Session

The pace of the global recovery had slowed by the time of the Board’s second session on the World Economic Outlook in March 2003, amid rising geopolitical uncertainties related to Iraq, the continued adverse effects of the fallout from the bursting of the equity market bubble, and rapidly changing conditions.

The global economy had been resilient, Directors noted, and in many industrial countries the fundamentals remained sound. They agreed that a global recovery should gradually reassert itself, achieving global GDP growth of just over 3 percent in 2003 under the baseline scenario of the World Economic Outlook Such an outcome would be supported by a pickup in confidence, the abating of the headwinds to growth from the bursting of the equity bubble, the policy stimulus in the pipeline, and the inventory cycle. In addition, with corporations in both the United States and Europe having relatively high cash balances, investment could respond relatively quickly. Nonetheless, Directors acknowledged that considerable uncertainties and risks gave cause for concern for the economic outlook, given the fragility of the global recovery and the likelihood that the resiliency of the world economy to shocks might have weakened. Developments in the oil market, in particular, would need to be monitored closely.

The economic impact of a conflict in Iraq was very difficult to quantify, Directors recognized. They considered that the balance of the other risks to the outlook was principally on the downside, and that sluggish growth could persist even in the absence of a war. Three elements underpinned this caution. First, the global recovery remained heavily dependent on the United States, and there was no obvious candidate to take up the slack if growth in the United States faltered. A disorderly adjustment in response to global imbalances—involving a sharp depreciation of the U.S. dollar—remained a risk. Second, the possibility of further declines in mature equity markets could not be ruled out, as earnings expectations remained relatively optimistic, and an adjustment in housing prices in some industrial countries was also possible. Third, despite progress, a number of emerging market countries remained vulnerable to a deterioration in the global environment. Notwithstanding these downside risks, Directors regarded sustained global deflation as unlikely, although they did not rule out price declines in individual countries.

With inflationary pressures in general quite moderate, Directors agreed that monetary policies in major industrial countries would need to remain accommodative. With regard to fiscal policies, the situation differed by country. In the short run, Directors acknowledged that the scope for fiscal tightening was constrained by the cyclical situation. Automatic fiscal stabilizers should generally be allowed to operate, although fiscal consolidation remained a clear medium-term priority in many industrial countries with high levels of public debt and mounting pressures from aging populations. Directors urged an acceleration of structural reforms to boost confidence and domestic demand growth—particularly in Europe and Japan—in order to reduce global dependence on the United States and foster an orderly reduction in global imbalances.

Policymakers would need to remain vigilant to changing circumstances, Directors underscored, and be flexible and ready to adapt to them as events unfold. Close international cooperation and dialogue and concerted efforts would be required to confront global uncertainties and boost global confidence. Directors considered that a strong push to advance multilateral trade negotiations under the Doha Round (see Box 5.7) should be a key ingredient of such efforts.

Major Currency Areas

Directors expected the United States to continue to lead the global recovery. They observed that while some U.S. economic fundamentals—notably productivity performance—remained strong, some U.S. economic data had been disappointing, reflecting weakening consumer confidence and spending. Several factors contributed to downside risks to the U.S. outlook. These included uncertainties about conflict in Iraq and about whether the bubble-period excesses had been fully worked out, and the emergence of fiscal deficits alongside the large current account deficit. The current stance of monetary policy was broadly appropriate, Directors observed, but further easing could be necessary if downside risks to growth were to materialize, although several noted that the scope for doing so was becoming increasingly limited. On fiscal policy, Directors viewed the U.S. administration’s tax proposals as having some merit from a structural perspective, but believed that if they were implemented they would significantly worsen the medium-term fiscal position, and might be procyclical if the economy picked up as expected under the baseline scenario. They underlined the importance of restoring investor confidence to underpin the recovery, and called for strict enforcement of enhanced corporate governance rules.

While the euro area Asia were a bright spot was not experiencing serious imbalances and its fundamentals remained generally strong, Directors viewed developments in the area with concern. Growth continued to disappoint, and forecasts for 2003 had been revised down sharply. The appreciation of the euro, balance sheet strains, and prospective fiscal tightening in a number of countries were all likely to weigh on the regional economy. Within this overall picture, Directors viewed the situation in Germany—where the economy had stagnated and the financial sector had come under increasing strain—with particular concern.

The recent move by the European Central Bank (ECB) to cut interest rates was welcomed, and many Directors saw scope for further monetary easing to reinvigorate growth. In the fiscal area, with budgetary positions in a number of countries in Western Europe having become more difficult over the past year, Directors noted that the challenge in the near term would be to avoid adding unduly to economic headwinds through fiscal retrenchment, while strengthening the credibility of the Stability and Growth Pact (SGP). To achieve this, Directors believed that structural deficits would need to be reduced toward the medium-term norm of a fiscal position close to balance or in surplus. Most Directors supported the full play of automatic stabilizers around the consolidation path, even if this were to result in deficits in 2003 above the 3 percent of GDP deficit limit. An overshooting of the deficit limit in the present circumstances was not warranted, in the view of a few Directors, however, as it might undermine confidence in the fiscal framework without bringing significant short-term benefit to economic activity.

Box 1.1Key Economic and Financial Developments, April 2002 to May 2003

Global economic growth in 2002 was only modestly higher than in 2001. Relatively strong growth in the first quarter of 2002 was followed by a gradual slowdown extending to the end of FY2003. World trade volume picked up after stagnating in 2001, but its growth was the weakest since the global recession of the early 1980s (see Figure 1.1). Foreign direct investment inflows to developing countries fell during 2002. However, portfolio investment and bank financing exiting from developing countries also slowed, leading to a net gain in private capital flows into developing countries. Several emerging market economies took advantage of improving market conditions and the narrowing of interest rate spreads in the second half of FY2003 to issue sovereign bonds.

Figure 1.1World Real GDP Growth and Trade Volume (Goods and Services)

(Annual percent change)

Sources: Haver Analytics; and IMF, World Economic Outlook (April 2003).

1 Average growth rates for individual countries, aggregated using purchasing-power-parity weights; the aggregates shift over time in favor of faster-growing countries, giving the line an upward trend.

Among the industrial countries, the economies of the United States, euro area, and Japan initially showed improvement—because of private consumption in the United States, net exports in the euro area, and a combination of the two in Japan. But business investment failed to pick up and buttress the recovery. The aftermath of the equity price bubble continued to weigh on the real economy. In the run-up to the war in Iraq in late 2002 and early 2003, geopolitical concerns heightened and oil prices surged. Consumer and business confidence fell steadily throughout the first quarter of 2003, up to the start of the war on March 20. First-quarter 2003 GDP growth was weak in all three economic areas—with activity essentially flat in the euro area and Japan. Labor markets also weakened—unemployment rose across the three areas. The cessation of military conflict in mid- April 2003 lessened geopolitical uncertainty and oil prices fell dramatically, although by the end of FY2003 there was little evidence of a renewal of the recovery.

Emerging market economies grew at quite different rates. Generally, in comparison with the industrial countries, growth was higher and the slowdown occurred a little later and was less pronounced.

Growth in Latin America was highly variable, with Argentina starting to pull out of its deepest recession in 20 years, while in Venezuela political turmoil late in 2002 led to a drop in activity. At the end of FY2003, economic growth was generally subdued, but financial conditions were somewhat more stable across the region.

The emerging market economies of Asia were a bright spot—registering robust growth throughout 2002, driven primarily by exports. China, in particular, continued to grow strongly, providing an increasingly important destination for exports of other economies in the region. The spread of Severe Acute Respiratory Syndrome (SARS), recognized in early 2003, however, affected the region adversely, especially those economies dependent on tourism-related services and local spending. By the end of FY2003, the rate of increase in new cases of SARS had slowed, but the economic and health effects remained uncertain.

Central and Eastern Europe grew strongly through the second half of 2002, despite a slowdown in the euro area. Activity in many of the countries in the region was boosted by positive foreign direct investment inflows in anticipation of entry into the European Union. Higher oil prices in the latter part of 2002 spurred growth in the oil-exporting countries of the former Soviet Union—Azerbaijian, Kazakhstan, and Russia. The strong increase in demand in these countries supported growth in the other countries in the reagion.

Before the buildup in tensions surrounding the war in Iraq, activity in the Middle East had picked up, with higher oil prices aiding oil exporters’ growth in particular. Despite the relatively short duration of the conflict, disruptions in trade and tourism and the dramatic fall in oil prices led to slower growth in early 2003. Continuous geopolitical tensions in the region dampened activity throughout FY2003.

Growth in most African countries held up better than in other regions, supported by improved macroeconomic policies and debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative. Serious problems troubled parts of Africa, however—- most important, deepening famine and drought in southern and eastern Africa. Economic conditions edged up in early 2003 reflecting developments in non-fuel commodity prices, which did not contract as much as in earlier global slowdowns, as well as debt relief, although the HIV/AIDS pandemic has remained a serious threat, reducing life expectancy and negatively affecting growth prospects.

Inflationary pressures across the globe remained subdued and wage increases were generally moderate. With the run-up to the war in Iraq and associated uncertainties, energy prices rose markedly toward the end of 2002 and at the beginning of 2003, but fell back at the end of the war. In exchange markets, the U.S. dollar depreciated during the financial year on a trade-weighted basis, while the euro appreciated.

Monetary policy policies remained accommodative in most industrial countries, with falls in policy interest rates in most cases. The stance of fiscal policies varied. Policy was loosened in the United States as a result of tax cuts, but policies were neutral in the euro area.

Regarding developments in financial markets, nominal government bond yields in mature markets declined sharply over the financial year, with the U.S. 10-year treasury note reaching a 41-year low of 3.56 percent on March 10, 2003. Slowing growth prospects and low inflation, declining equity prices, geopolitical uncertainty, and declines in central bank policy rates contributed to the fall in yields.

Mature equity markets remained under pressure throughout much of FY2003 (see Figure 1.2). Uncertain prospects for corporate earnings, lingering effects of the bursting of the high-tech bubble, and the war in Iraq weighed heavily on mature equity markets. Record numbers of bankruptcies in the United States, corporate fraud cases, and lapses in corporate governance hurt investor confidence. The S&P 500 lost 15 percent and closed FY2003 down 40 percent from its March 2000 peak, despite a postwar rally and an eventual easing of risk aversion. European equities fared worse. The Eurotop 300 lost 33 percent to close 50 percent below its March 2000 peak. Japanese shares ended FY2003 at a 19-year low. In local currency terms, the Topix lost 26 percent in FY2003, to close 72 percent below its December 1989 high.

Figure 1.2Equity Market Performance

(May 2002=100

Source: Bloomberg L.P.

Emerging debt markets recovered in the second half of FY2003—with considerable differences across regions—and bond spreads narrowed to historical lows in many cases. Concerns over policy continuity, especially in Latin America, triggered a pronounced sell-off of emerging debt markets during the first half of the year. Investors regained confidence after elections in Brazil and Turkey and following policy pronouncements and reform initiatives. These developments combining with investors seeking higher-yielding investments in global markets paved the way for one of the longest emerging market bond rallies in history. The EMBI+ spread tightened from a high of 1,040 basis points in September 2002 to 576 basis points by the end of FY2003 (see Figure 1.3). In tandem, primary debt markets reopened in October 2002, after a long period of inactivity, and many emerging market governments met their 2003 market financing targets early in the year.

Figure 1.3Sovereign Spreads

(In basis points)

Source: J.P. Morgan Chase.

Directors called for a greater sense of urgency by European countries to address structural rigidities in product and labor markets. While a number of important steps had been taken, European unemployment rates generally remained high, and participation rates were much lower than in other advanced countries. Labor market rigidities, most Directors agreed, played an important role in explaining the persistent unemployment in a number of industrial countries. This was shown by the contrasting experiences of countries that had undertaken comprehensive reforms—and observed a steady decline in structural unemployment—and those that had made little progress—and seen further increases in unemployment rates. They called for comprehensive labor market reforms in the euro area that, particularly if complemented with product market reforms, would yield significant gains in the form of lower unemployment and higher output. Proposals recently put forward by the German authorities to improve incentives to work and begin dismantling excessive job protection were welcome. If these measures were bold and implemented in full, Directors considered that they would have a favorable effect on business confidence and job creation.

The economic situation in Japan remained difficult, Directors noted. The economy experienced a modest cyclical recovery during 2002, but growth was expected to remain flat in 2003. Moreover, deflation continued, and survey evidence suggested that deflationary expectations were becoming more widespread and persistent. The Bank of Japan, most Directors urged, should be more aggressive in both its monetary policy actions and its communications strategy to arrest deflation. Also, the effectiveness of monetary policy would be improved by measures to strengthen the financial sector. Given the large budget deficit and high public debt levels, Directors emphasized the need for the authorities to establish a credible medium-term fiscal consolidation strategy and to implement key fiscal reforms. Most Directors believed that Japan should make a gradual start toward fiscal consolidation, unless the authorities were to push ahead with a much more aggressive structural reform agenda. Reforms to strengthen banks and corporations were welcomed, although Directors underscored that the reforms did not go far enough to resolve the long-standing problems in these sectors.

On asset price bubbles, Directors observed that the busts in equity markets of the past few years had been quite similar to earlier episodes in terms of magnitude, length, and cross-country synchronization of the price declines. The stock market booms in Europe and North America in the late 1990s led firms to borrow and invest well ahead of demand, thus increasing corporate vulnerability to a decline in stock prices and aggregate demand. Directors also noted concerns about the high levels of corporate debt compared with equity, especially in Europe, which could dampen investment spending during the recovery.

Emerging Markets

Growth prospects in emerging market countries generally remained relatively favorable, Directors observed, although performance and prospects varied significantly within this group. Many countries were implementing disciplined fiscal and monetary policies and advancing with structural reforms, and were in a better position to withstand external shocks. Nevertheless, downside risks remained, given the weaker outlook in industrial countries and uncertainties related to the situation in Iraq.

Recent signs of a pickup in activity in much of Latin America and the improvement in market sentiment were welcome, although Directors noted that the situation in a number of countries remained difficult. In Argentina, the economy might be over the worst, but policy continuity would be fundamental, and the market signals sent by presidential candidates would be crucial in shaping expectations. In Brazil, the new government’s decisive actions to maintain macroeconomic stability and fiscal discipline had helped reduce uncertainties in financial markets. Chile and Mexico were relatively more sheltered from deterioration in external financing conditions, reflecting their strong policy record and relatively high degree of integration with the world economy. For the region as a whole, Directors emphasized the importance of sustained efforts to lower public sector debt levels and improve the maturity structure of the debt. Directors identified other key policy priorities for the region, including orienting monetary policy to achieve low inflation with exchange rate flexibility, deepening domestic financial intermediation, and introducing reforms to liberalize trade, improve social safety nets, and increase labor market flexibility.

Directors commended the impressive economic performance in emerging Asia underpinned by both exports and domestic demand, with countries moving most vigorously to implement structural reforms generally seeing the most robust growth, and noted that growth in emerging Asia will remain reliant on the global economic environment. The continuation of accommodative monetary policies was generally appropriate, in the Board’s view, and automatic fiscal stabilizers should be allowed to operate in most countries. Further progress with structural reform, particularly in the financial sector, was seen by Directors as necessary to underpin stronger domestic demand and help contribute to a reduction in global imbalances, and the generally comfortable external sector positions in the region provided the foundation for pressing ahead with the unfinished agenda of structural reforms. In the near term, the oil-exporting countries faced the difficult task of managing very large balance of payments inflows. Directors encouraged the authorities to permit flexibility in the exchange rate and target monetary policy on achieving a further reduction in inflation. Over the medium term, they noted, the challenge would be to manage the oil wealth appropriately.

In Central and Eastern Europe, strong foreign investment continued to underpin growth in some countries, as European Union accession grew nearer. Significant challenges lay ahead, Directors noted, as governments looked beyond accession to the requirements associated with adoption of the euro. They observed that, although the picture varies across countries, the need for fiscal restraint would likely remain a central focus of policy for most countries in Central and Eastern Europe to underpin market confidence and bolster growth. In Turkey, following a better-than-expected performance last year, economic and financial conditions had deteriorated in early 2003, and Directors underscored the urgent need for the government to pursue fiscal restraint and structural reforms to sustain confidence.

Growth in oil-exporting countries of the Commonwealth of Independent State (CIS) had been buoyed by rising energy prices. Slowing structural reforms could dampen investment spending, particularly in Russia, Directors cautioned, and could weaken medium-term prospects. Directors called upon the authorities in the CIS countries to reinvigorate the reform process, including by strengthening banking systems. They suggested that the seven low-income CIS countries (Armenia, Azerbaijan, Georgia, the Kyrgyz Republic, Moldova, Tajikistan, and Uzbekistan) give priority to accelerating structural reforms to strengthen the investment climate in order to ensure the sustainability of the uptick in growth seen in many of the countries and to help address the high public debt levels that threaten fiscal sustainability in several of the countrie.

Growth in the Middle East weakened in 2002, although countries where reforms had progressed fastest experienced more rapid growth. Many countries in the region were benefiting from the increase in oil prices, Directors observed, but the regional security situation was weighing on foreign investment and tourism. The key policy challenge over the medium term across the region, Directors noted, would be achieving sustained high GDP growth in order to reduce unemployment and absorb the rapidly growing labor force. Efforts to energize the private sector, liberalize trade, and develop human resources should remain at the core of the reform agenda.

Macroeconomic policy and structural reform implementation had improved in many African countries. Nevertheless, growth in Africa slowed in 2002 owing to poor weather and continuing political turmoil affecting several countries. The central challenge in Africa, in Directors’ view, was putting in place the conditions to reach the Millennium Development Goals (see Chapter 5). As stressed in the New Partnership for Africa’s Development (NEPAD), this would require a substantial improvement in the climate for private investment, which in turn would depend on actions to restore peace and political stability; improve governance, infrastructure, health, and education; liberalize markets and trade; and address the HIV/AIDS pandemic. Achieving these goals, Directors underscored, would require the financial support of the international community and greater market access for the exports of African countries.

Impact of Institutions on Economic Performance

Directors observed that improvements in institutional quality are found to raise the level and growth rate of GDP per capita, and lower the volatility of growth. On the basis of these findings, Directors agreed that developing countries would significantly build up their economic performance if they improve the quality of their institutions, while maintaining sound macroeconomic policies. In the Board’s view, some general principles might frame the strengthening of institutions. For example, successful market-based economies need institutions that protect property rights, uphold the rule of law, provide appropriate regulation of markets, support macroeconomic stability, and promote social cohesion and stability.

Institutional design and reform would inevitably have significant country-specific elements requiring adaptation and innovation to suit local conditions, Directors stressed. Some key elements of institutional reform include greater competition, including through trade openness, which can help rein in the power of vested interests, and broader information flows and transparency, which can improve policy choices and reduce the scope for corruption. In addition, external “anchors,” such as those associated with the EU accession process, have also proved effective for strengthening institutions. In the final analysis, Directors felt, firm domestic ownership and commitment remain the most vital ingredients for institutional reform.

Global Financial Stability Report

The Global Financial Stability Report (GFSR) was introduced in March 2002 to provide timely and comprehensive coverage of both mature and emerging financial markets and to identify potential fault lines in the global financial system. The Executive Board discussed four issues of the report during FY2003, with the last discussion occurring in March 2003. Discussions covered both recent developments and topics of special interest.

Key Developments

At their May 2002 discussion, Directors noted that in the context of an improved global economic outlook, no imminent threat to global financial stability was evident. Stock prices were broadly unchanged in the United States and Europe in the first quarter of 2002, even as concerns over the recovery and quality of reported earnings weighed heavily on the stock prices of highly leveraged firms and of firms that had been active in mergers and acquisitions. At the same time, emerging market bond and equity markets had rallied, reflecting new inflows from dedicated investors and increased interest from crossover investors. Bond market flows to emerging markets had increased during the first quarter of 2002, Directors noted, which, in spite of decreased overall capital flows, had allowed many governments to satisfy substantial portions of their 2002 financing needs.

Conditions in global financial markets had deteriorated significantly by the time of the Board’s second session on the GFSR in August 2002, reflecting eroding investor confidence and heightened risk aversion. A combination of corporate earnings disappointments, increased investor pessimism and uncertainty about the earnings outlook, and further corporate accounting scandals had triggered repricings and volatility in a range of markets. Higher-risk borrowers, including those in emerging markets, faced tighter terms of market access as investors had reduced their appetite for risk. In addition, portfolio rebalancing by international investors appeared to have contributed to downward pressure on the U.S. dollar and on U.S. asset prices.

At their November 2002 meetings Directors noted that global investor sentiment in the third quarter had continued to be weighed down by concerns over the strength and durability of the global economic recovery, the prospects for corporate profits, and geopolitical conditions, and that this contributed to the tiering by credit quality and to continued difficult financing conditions for higher-risk corporate and sovereign borrowers. Emerging market countries had continued to face a difficult environment, characterized by unusually high financial market volatility and increased risk aversion, Directors observed. This environment, coupled with earlier concerns over policy continuity in some key emerging markets, resulted in a continuation of sharply reduced flows and tight external financing to emerging markets as a group, affecting in particular noninvestment-grade issuers. Although in the primary markets unsecured access had been effectively closed to noninvestment-grade issuers in Latin America, broad-based contagion had nevertheless been limited, with investment-grade issuers and Asian and Eastern European issuers benefiting from relatively open access.

In the March 2003 session, Executive Directors observed that the global financial system had remained resilient, despite significant geopolitical uncertainties and a hesitant and uneven global economic recovery. Markets continued to work off the excesses of the equity asset price bubble, and the bursting of the bubble had revealed underlying structural weaknesses, which required carefully crafted policy responses.

In an unsettled international environment, Directors noted, consumers, businesses, and investors had remained on the sidelines. They felt that this uncertainty could persist for some time. In this difficult environment, policies to improve market confidence on a sustained basis would remain of critical importance. Directors underlined their endorsement of continued supportive macroeconomic policies and wide-ranging measures in the structural area to address underlying market vulnerabilities.

Major Financial Centers

In the March session also, Directors noted that a gradual improvement of financial conditions in mature markets had begun to take hold, and, in particular, U.S. household and corporate sectors’ balance sheets had strengthened somewhat. This progress was still fragile, they cautioned, and underlying vulnerabilities would require continued vigilance and policy attention. The corporate sector in a number of countries faced growing funding gaps in defined-benefit pension plans, as a result of lower equity prices and higher present values of pension liabilities owing to lower interest rates. Directors observed that improvement in the U.S. household sector’s balance sheet rested crucially on continued strength in the housing market.

The financial sector in the mature economies presented a mixed picture, Directors considered. While banks with a strong retail franchise had performed reasonably well, wholesale and investment banks had been hard hit. Despite the authorities’ renewed initiative to tackle the situation, the persistent weaknesses of Japanese banks remained a matter of concern. A number of Directors also highlighted the difficult situation facing the German banks in a context of low earnings, high costs, a deterioration in loan quality, and an erosion of hidden reserves as a result of the decline in the German equity market. Close monitoring of the deteriorating financial condition in the insurance sector in several European countries was also needed. Directors noted that the protracted weakness of equity markets had resulted in lower returns on assets and prompted sales of equity holdings, in some cases, to comply with solvency regulations.

The tendency of investors to remain on the sidelines had resulted in a significant accumulation of high-quality, short-term cash balances by retail and institutional investors. Directors saw the potential for deployment of these balances into more productive assets once investor sentiment recovers as a generally positive factor in the outlook. At the same time, a number of Directors cautioned that a sudden shift in asset preferences and prices could expose the unhedged positions of commercial banks and broker-dealers to considerable interest rate risk. Still others expressed concern about the capital strength of the government sponsored mortgage agencies in the United States. A number of Directors also pointed to the increased sensitivity to interest rate differentials resulting from the sizable reallocation of net capital flows to the United States away from equities and direct investment toward fixed-income securities.

Emerging Market Financing

An unsupportive external environment, together with investor concerns over the risk of policy discontinuity in key emerging market borrowers, had limited the availability and raised the cost of capital for most emerging market borrowers throughout most of 2002. Directors were encouraged that the easing of global financial market conditions in the fourth quarter had led to a reopening of capital markets to many issuers, and that investor concerns about the direction of future polices in some major emerging market economies had abated. However, this recent development should be seen against the backdrop of the longer-term decline in capital flows to emerging market borrowers, which deserved further attention. The continued “feast or famine” dynamic in the primary market for emerging market bonds highlighted the importance of self-insurance to mitigate—through sound economic frameworks and institutions—externally induced market volatility.

Recent market developments provided evidence, Directors noted, that more discriminating investors were responding positively to the sustained pursuit of sound policies. Nevertheless, it would remain important to consolidate this encouraging development and further reduce risks of contagion. In particular, Directors highlighted the importance of further efforts, including by the IMF, to help investors distinguish among borrowers, and of policies aimed at promoting financial stability. They welcomed the improvements in banking sector regulation and capitalization in many emerging markets. Progress had varied by region, however, and they noted that further measures were needed to bolster domestic banking systems. Directors welcomed the recent issuance by Mexico of a bond that included collective action clauses (CACs; see Chapter 3), and encouraged other issuers to include CACs in future bond placements. They encouraged IMF staff to provide members with the necessary advice to further this aim.

Promoting Stability

The GFSR’s primary purpose is to point to weaknesses and vulnerabilities in the global financial system so that policymakers can take steps to prevent crises. During FY2003, the GFSR suggested a variety of policy actions, and Directors highlighted several policy measures that, taken together, should help ward off an excessive cutback in risk taking, rebuild investor confidence, and strengthen the markets’ self-correcting mechanisms. At the August 2002 Board meeting, Directors stressed the importance of continued financial surveillance by the IMF, including through such instruments as the Financial Sector Assessment Program (FSAP) and Reports on the Observance of Standards and Codes (ROSCs). They called on financial regulators to be vigilant for signs of further weakness in key institutions and markets. In advanced countries, policies should continue to support economic activity and an orderly reduction of imbalances over the medium term. In addition, Directors emphasized that strong implementation and enforcement of steps to improve corporate governance, accounting, disclosure, and transparency, together with close monitoring by national authorities and the IMF, would be helpful to strengthen markets’ self-correcting forces. In emerging market countries, strong policies to bolster macroeconomic and financial stability would help investors to discriminate more clearly between countries as investment destinations. National authorities should also encourage the development of sound and diversified domestic financial systems.

In November 2002, Monetary policy had continued to strike the right balance between the risks of inflation stemming from adverse one-off supply shocks and the ongoing weakness of activity, Directors considered. With the recovery expected to be gradual and inflation expected to move back below the European Central Directors emphasized that macroeconomic policies in the advanced economies should remain responsive to any signs that economic recovery might be faltering. Speedy conclusion of the Doha trade negotiations and implementation of other trade liberalization moves would improve confidence in economic prospects, and provide emerging market countries with an opportunity to increase their export earnings and, ultimately, strengthen their debt-servicing capabilities. Supervisors of non-bank financial institutions, particularly insurance companies—and, in a number of cases, pension funds—should be vigilant for signs of significant capital erosion stemming from falling asset prices. Furthermore, the increased reliance of financial institutions upon credit risk transfer instruments to manage their risks warranted enhanced disclosure and regulatory scrutiny.

The continued ability of some emerging-markets to tap international capital markets in the then-current environment, in Directors’ view, illustrated the importance of strong commitment to the continued implementation of policies aimed at maintaining macroeconomic and financial stability and strengthening institutional frameworks. More generally, Directors stressed that firm commitment to the preservation of property rights, the rule of law, transparency, and stability in the legal and regulatory frameworks were key to fostering investor confidence and building a stable investor base.

In March 2003, Directors saw a continued need for strong confidence-building measures. In the structural area, Directors highlighted the need for legal and regulatory frameworks to support corporate and financial sector restructuring. In the case of Japan, the low profitability of Japanese financial institutions and the problem of nonperforming loans were in need of urgent corrective action. German banks, Directors also observed, would need to address their low earnings through cost reduction measures, including consolidation.

Directors observed that the “feast or famine” dynamic in emerging market financing and persistent credit tiering underscored the need for the consistent implementation of sound macroeconomic policies. In addition, they encouraged continued measures to deepen local securities markets, which could help provide a buffer against changing global financial conditions.

Financial Market Activities of Insurance and Reinsurance Companies

Another major theme highlighted by the GFSR was the role of insurers and reinsurers in global financial markets. At the May 2002 Board meeting, Directors noted that such companies had become an increasingly important class of institutional investors and financial intermediaries, which conveyed important benefits to international financial markets by adding to market liquidity and the diversity of market participants. In this context, more information would need to be made available on the market activities of insurance and reinsurance companies, by category of insurance (such as life and non-life insurance), and particularly in newer market segments such as credit derivatives. In addition, Directors suggested that the regulatory and supervisory frameworks might need to be modified to reflect these companies’ expanding asset-market activities and any attendant implications for financial stability.

The international systemic risks associated with insurers’ financial markets activities, Directors broadly agreed, seemed relatively limited compared with those of the major internationally active investment and commercial banks. Nevertheless, uncertainties remained about whether insurers’ capitalization and risk management systems fully reflected the risks associated with their expanding financial market activities. There were also questions about whether these activities contributed to a migration of financial risks from the banking to the insurance sector. These issues complicated an assessment of the potential systemic risks associated with the expanding financial markets activities of insurance and reinsurance companies, and underscored the importance of improved disclosure and transparency.

Promoting Local Securities Markets

In their May 2002 meeting, Directors also noted that the experience with the banking crisis and the loss of access to international capital markets during the Asian crisis of the late 1990s had emphasized the need to develop local securities markets to provide a more stable source of sovereign and corporate funding. Directors considered that the relatively low dollar equivalent returns on emerging market equities over the past decade underlined the need both for more stable macroeconomic conditions and for an adequate domestic and international investor base for this asset class. The migration of top-quality emerging market corporates to major mature market financial centers, Directors noted, had taken a toll on the liquidity of emerging equity markets, and they emphasized that improvements in the trading infrastructure in emerging markets would be crucial for expanding emerging market equities as an asset class.

At the Board’s August 2002 discussion, Directors endorsed the development of local bond markets as an alternative source of financing, and were encouraged by progress made in this area since the Asian crisis. While by no means a panacea, local bond markets could mitigate the adverse effects of lost access to international capital markets or bank credit, while widening the menu of instruments to deal with inherent currency and maturity mismatches faced by emerging markets borrowers. Well-developed primary and secondary markets, and the roles of foreign investors in these markets, were important, Directors emphasized.

Despite their rapid growth, emerging local bond markets remained a small part of the increasingly global bond market. Directors stressed that the deepening of the local government bond market should not come at the expense of depth in the corporate bond market, where progress had often been slower in part as a result of crowding out by the government sector.

At the November 2002 meeting, Directors welcomed the discussion of financial derivatives in emerging market economies noting that the rapid expansion of these instruments over the past decade was among the key factors facilitating the increase in global cross-border capital flows. Emerging derivatives markets present opportunities as well as certain risks, they observed. While derivatives could play a positive role in contributing to a more efficient allocation of risks in financial markets, these instruments could also be used to avoid prudential safeguards and take on excessive leverage. In some of the recent emerging market crisis episodes, Directors noted, the rapid unwinding of derivative positions had accelerated capital outflows and exacerbated the crisis dynamics, although it was stressed that derivatives were not the ultimate cause of the crises. Moreover, deep and liquid local derivatives markets could help market participants to price and manage the risks associated with investing in emerging markets more efficiently.

Measures to ensure the smooth functioning of local securities markets— through, among other moves, improving market infrastructure and transparency, strengthening corporate governance, developing liquid benchmarks, and promoting a domestic institutional investor base—were highlighted at the March 2003 session. Directors stressed that steps to develop local securities markets needed careful sequencing, with the development of money markets typically being a crucial first step in developing bond and derivatives markets.

Directors cautioned against heavy resort to bonds indexed to foreign currencies, which could increase vulnerability to external shocks and contribute to unstable debt structures. However, inflation-indexed bonds could be a useful instrument to deepen local bond markets. While local derivatives markets could facilitate the management of financial risk, Directors stressed that the development of such markets needed to be based on a strong supervisory and regulatory foundation.

Although local securities and derivatives markets had grown substantially over the last years, Directors observed that they had not yet developed enough to provide full insurance against the closure of banking or international markets, which in many cases may remain a remote prospect. Directors supported continued efforts to develop these markets given their potential to improve emerging markets’ resilience

Finally, the Executive Board agreed with IMF Management’s suggestion to shift the GFSR from a quarterly to a semiannual publishing schedule beginning in March 2003.

Regional Surveillance

Central African Economic and Monetary Community

In June 2002, the Board discussed developments in the Central African Economic and Monetary Community (CAEMC), whose members are Cameroon, the Central African Republic, Chad, the Republic of Congo, Equatorial Guinea, and Gabon. Directors commended the authorities of the CAEMC countries for their continued efforts to intensify regional economic integration and surveillance and to harmonize macroeconomic policies. Directors welcomed, in particular, the adoption of new convergence criteria and of a framework for surveillance over macroeconomic policies—while noting the need to build on this progress by strengthening aspects of implementation. The IMF’s dialogue with CAEMC, in Directors’ opinion, was a valuable complement to its bilateral surveillance over the member countries of the region.

Developments in world oil markets had permitted CAEMC countries to sustain satisfactory—albeit somewhat uneven—economic growth, and to increase their international reserves substantially. Nonetheless, Directors considered that domestic demand had been allowed to grow too strongly—reflecting a rapid expansion expansion in credit granted by the regional central bank and a procyclical fiscal policy. This had led to a rise in inflation and a deterioration in the external balance. Directors believed that the international reserve position and external competitiveness of the region remained broadly adequate. However, they stressed that the macroeconomic situation warranted a tightening of financial policies.

Discipline in the public finances must be the foundation of price and exchange rate stability, Directors underscored. While recognizing that the current fiscal position is strong, they considered that the management of the public finances could be improved. In particular, they urged that the relevant convergence criteria be adjusted to take into account the importance of oil revenues for most of the economies in the region: at present, a significant increase in the world oil price resulted in a procyclical rise in public expenditure. They suggested, for example, that fiscal goals could be based on a longer-term trend of oil prices, instead of the current price.

There was potential merit, Directors observed, in the planned establishment of an oil revenue stabilization fund, which could serve as a buffer against oil price fluctuations. For such a fund to be effective, regional surveillance over fiscal policy must be geared to avoiding procyclical spending and take into account developments in the non-oil deficit. There was support for the creation of a long-term savings fund as one of the routes available to benefit future generations—provided it were set up with appropriate safeguards and offered adequate returns.

Turning to monetary policy, Directors welcomed the plan to phase out statutory central bank financing of government deficits, although it was questioned whether 10 years was not too long a time frame for doing so. Regional financial markets were not well developed, Directors noted, and this inhibited the use of open market operations and other indirect monetary policy instruments. The sale of government bonds to substitute for central bank financing would help develop domestic money and capital markets and thus further strengthen monetary control. However, this reform would require a number of legal and institutional changes and would need to be prepared carefully. Directors supported the increase of commercial bank reserve requirements, provided these were adequately remunerated, as an important step to enhance the effectiveness of monetary policy by reducing excess liquidity. Changes along these lines would allow the regional central bank to pursue its goals more effectively and counter the recent unduly rapid growth of credit.

Regional financial integration requires a well-functioning banking system, Directors noted. Progress had been made in strengthening bank soundness in recent years, but there was scope for further improvement. They commended the authorities for their efforts to put in place an efficient regional payments system. Nonetheless, they stressed the need to go further in making effective the common banking license and developing a well-functioning interbank market—thereby creating a fully fledged regional monetary zone. The authorities’ determination to address problems of the arbitrary attachment of bank deposits was welcome, but Directors urged further steps to strengthen the financial framework and infrastructure, and they called for additional resources to be provided to the regional supervisory agency (the Central African Banking Commission, or COBAC) to enable it to work effectively.

Much remained to be done to implement fully the goal of a single market in the region, Directors noted. Thus, they welcomed the member countries’ decision to further liberalize trade through a simplification of the structure of the common external tariff and a reduction of average tariff rates. Directors stressed the importance of reducing barriers to trade in order to achieve an outward-looking customs union, and they welcomed a project to take stock of remaining regional barriers, with the help of donor countries. Member countries needed to fully implement the agreements they had reached, and thus demonstrate their commitment to putting regional integration goals above sectoral interests. Several Directors also noted that the region’s exports of cotton were adversely affected by subsidies in advanced economies.

Technical assistance to CAEMC members—especially in the areas of trade reform and monetary management—was important to strengthen the regional integration process, Directors underscored. They welcomed the amendment of the CAEMC Treaty to create an action group to combat money laundering and the financing of terrorism, and urged speedy passage and implementation of the proposed regional law addressing these activities.

Monetary and Exchange Policies of the Euro Area and Trade Policies of the European Union

In October 2002, the Board discussed the monetary and exchange rate policies of the euro area and the trade policies of the European Union.

With regard to the monetary and exchange rate policies of the euro are area, Directors congratulated the authorities for the smooth and successful changeover to euro notes and coins at the beginning of the year, which marked another milestone in European integration. However, overall economic performance in the euro area had been disappointing, with growth weaker and inflation higher than had been expected. While unanticipated shocks—-including oil price increases, animal diseases, the external slowdown, and financial market turmoil—contributed to this setback, the euro area showed a greater-than-anticipated vulnerability to shocks. In particular, structural rigidities were underlying factors responsible for the continued dependence of activity on foreign demand and for the persistence of inflationary pressures despite weak domestic demand.

In Directors’ estimation, the recovery would be rather gradual, with indicators pointing to continued tepid growth in the near term. The recovery was expected to pick up in 2003, led by consumption, as past price shocks dissipated, and in step with global developments. This would be helped by the overall sound economic fundamentals and the progress achieved on structural reform, as reflected in the relative robustness of the labor market. Nevertheless, Directors noted considerable downside risks, including those related to the fragile external environment and the impact of the recent turbulence in financial markets. Policies should focus on increasing both the pace and robustness of the area’s performance, Directors agreed, thus helping to strengthen world growth and facilitate an orderly adjustment of international payments imbalances. Macroeconomic policy in the period ahead would need to take account of possibly heightened uncertainty, and decisive action on structural reforms would be key to lifting the euro area’s growth potential and reducing its vulnerability to shocks.

Monetary policy had continued to strike the right balance between the risks of inflation stemming from adverse one-off supply shocks and the ongoing weakness of activity, Directors considered. With the recovery expected to be gradual and inflation expected to move back below the European Central Bank’s 2 percent upper limit for price stability, Directors agreed that monetary policy should maintain an accommodative stance. In view of the predominance and recent increase of downside risks to the recovery, they considered that a clear bias toward further monetary easing would be appropriate. The steps taken by the ECB to further clarify to market participants the relationship between the monetary framework and the policies that issue from that framework were welcomed by Directors. They saw the de facto narrowing of the range of desired inflation outcomes to the upper half of the 0-2 percent official definition of price stability as a useful step toward balancing the benefits of an ambitious inflation objective against the benefits of providing for easier adjustment to shocks and guarding against the risks of deflation. Directors also welcomed the ECB’s move toward integrating broader financial market and real developments into its analysis of monetary developments. However, a number of Directors considered that developments in the monetary aggregates are useful for predicting inflation only in the longer term. Therefore, these Directors suggested that less emphasis be placed on the role of developments in monetary aggregates, which should be used primarily as long-term information variables to support policy decisions. Several Directors highlighted, in this context, that money and credit developments can provide valuable signals of emerging financial imbalances that could lead to asset price bubbles.

The appropriateness of the Stability and Growth Pact (SGP) as a fiscal framework for the euro area was discussed by the Board, and in particular how it should best guide the adjustment of members that had not yet met the Pact’s consolidation objectives. Directors generally considered the SGP to be basically in line with the requirements of both the area members and the fiscally decentralized monetary union and to provide a forward-looking framework that is reasonably well-tuned to the long-term pressures and debt sustainability issues stemming from the costs of aging populations. However, several Directors considered that the SGP’s standing had been hurt by public perceptions that countries were held accountable for achieving nominal balance targets regardless of cyclical developments, resulting in procyclical fiscal policy responses. Therefore, these Directors welcomed recent announcements emphasizing the focus on structural balances, although a few Directors cautioned that these may be more difficult to explain to the public.

The recent collective reaffirmation by the euro area authorities of their commitment to avoid excessive deficits and to uphold the SGP objective of achieving and maintaining budgetary positions close to balance or in surplus over the economic cycle was welcomed by the Board. A coordinated consolidation approach would be helpful for further enhancing the credibility of the Pact. Directors also noted the positive role that the Pact had played in supporting most members of the euro area in achieving an underlying fiscal position that was close to balance or in surplus. They welcomed these fiscal consolidation efforts, and urged that fiscal policies in these countries allow the automatic stabilizers to operate fully, as envisaged by the Pact.

In several countries, most notably the three largest, fiscal adjustment had lagged, in particular during periods of strong growth. These countries, Directors suggested, faced the particular challenge of striving to maintain the ambitious medium-term target of achieving fiscal balance while being cognizant of the shorter-term fragility of the cyclical outlook and the demand implications of adjustment. Meeting this challenge would require choosing a path of adjustment to medium-term fiscal targets that both signals credible adherence to SGP rules and maintains a sustainable pace of consolidation. In light of this, Directors endorsed the view that the best way forward would be a concerted and credible commitment by the three largest countries to adjust their underlying fiscal positions by at least ½ of 1 percent of GDP per year over the next several years until they reached close-tobalance structural positions. Such an approach would impart needed fiscal credibility at both the national and area-wide levels, which could significantly lessen the short-term negative demand effects of the adjustment, particularly if fiscal consolidation is anchored in expenditure reforms. They also saw a need for a comprehensive understanding that—provided the 3 percent limit is not breached—the automatic stabilizers should be allowed to play fully around those adjustment paths.

The scope for raising the area’s potential through structural reforms remained large, Directors stressed, and it had become increasingly urgent to implement the remaining reform agenda with perseverance, in particular to support the reabsorption of labor. Directors welcomed the “new European paradigm” of employment-intensive growth, but noted that as the employment-generating effects of past reforms wear off, further labor market reforms—together with continued wage restraint—would become an increasingly pressing priority to maintain the paradigm and bolster the area’s resilience. Priority should be given, Directors also emphasized, to the further integration of product markets—a long-standing rationale for the EU’s existence that continues to be hindered by the slow progress in liberalizing trade in services. The new impetus to, and awareness of gains from, financial sector integration was welcomed, and, in this context, Directors noted, in particular, the agreement on the Lamfalussy process for speeding up the implementation of the Financial Services Action Plan in securities markets, and the recent agreement on its extension to the banking and insurance sectors.

Directors acknowledged that area-wide statistics were adequate for surveillance purposes but called for improving the timeliness of quarterly national accounts data, and the quality of labor market and short-term business cycle statistics.

With respect to trade policies of the European Union (EU), Directors emphasized that, given its prominent role in world trade, the EU has a special responsibility to pursue liberal trade and agricultural policies, improve access to developing country exports, and advance the agenda of multilateral trade liberalization. They welcomed the leading role played by the EU in the successful launch of the Doha round of trade negotiations and the priority given by EU trade policy to further liberalization and better trade rules in the multilateral context. They were encouraged by the fact that further escalation over transatlantic trade disputes, which could have undermined progress under the Doha round, had so far been avoided. Reform of the Common Agricultural Policy (CAP) should be a key policy priority for the EU, Directors considered, given the costs it imposes on EU consumers, trading partners, and agricultural markets. The proposals under the mid-term review of the CAP, which involve delinking financial support from production, were seen as a first crucial step in this direction. Directors called for determined political leadership in order to pursue reform comprehensively, including elimination of agricultural export subsidies.

The EU’s commitment to increase developing countries’ access to its market was welcomed by Directors, and they urged the EU to go further by being prepared to eliminate or reduce tariff peaks and tariff escalation, especially on exports of developing countries. In textiles and clothing trade, quota removals should be accelerated in order to help smooth the adjustment in both EU industries and in those developing country suppliers currently protected by the quota system.

Eastern Caribbean Currency Union

In January 2003, the Board discussed recent economic and policy developments in the Eastern Caribbean Currency Union, which comprises Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.

The region had faced a series of harmful shocks, Directors observed, including natural disasters, repercussions from the events of September 11, 2001, and the global economic slowdown. In particular, the weakness of the tourism sector had contributed to an unprecedented overall decline in GDP in both 2001 and 2002. These developments had worsened the region’s difficult economic challenges, but Directors stressed the urgency of addressing these challenges with determination. Priority would need to be given to correcting the deepening fiscal imbalances and to safeguarding the stability of the currency board arrangement and the financial system. At the same time, structural reforms should aim at strengthening the region’s competitiveness and growth potential.

Efforts at fiscal consolidation and stabilizing public debt ratios, Directors noted, require a range of actions. Expenditure measures should include wage restraint, improved public expenditure management (informed by World Bank public expenditure reviews), and greater focus on public sector investment projects that are geared to growth and poverty reduction and funded largely by grants and concessional loans. To strengthen the revenue effort, Directors urged an early reduction in tax exemptions and discretionary concessions, and a broadening of the tax base, preferably on a regional basis and through the introduction of a VAT-type tax and reduced reliance on trade tariffs. Strengthened public debt management will also play a crucial part in improving fiscal outcomes and lessening vulnerabilities.

The ongoing work coordinated by the Eastern Caribbean Central Bank (ECCB) in the tax, expenditure, and debt management areas was welcomed by Directors. They commended the ECCB for its efforts to support fiscal reforms in the region, particularly in the context of stabilization programs, and saw the fiscal benchmarks being developed as a useful commitment mechanism to improve fiscal performance. The fiscal authorities needed to take full ownership of these regionally coordinated initiatives, Directors stressed, and their full and determined implementation would be key to ensuring fiscal sustainability. Peer review and the regular monitoring of members’ performance against the benchmarks would help ensure that all members achieve—at a minimum—the benchmarks over the medium term. Directors also underscored the need to improve fiscal transparency and governance in the region, and suggested that fiscal ROSCs for the members of the ECCB would be helpful in this regard.

Directors noted the mixed assessment of the health of the financial systems in the member countries, and called for measures to ensure bank soundness going forward. They welcomed plans to strengthen the domestic bank supervisory and regulatory regime in accordance with the Basel Core Principles, as well as the amendments to the Banking Act and the ECCB Agreement Act, and looked forward to their early enactment. Establishing uniform agencies in each jurisdiction to regulate nonbank financial institutions and the offshore financial sector was a matter of urgency, Directors stressed. Problem banks needed to reduce their nonperforming loans and would, in some cases, have to be recapitalized.

Recent progress toward strengthening regulation and supervision in the offshore financial sector was welcomed by Directors, but prospects remained dim for sustaining a vibrant offshore industry over the medium term in the region. While efforts to raise supervision to international standards needed to continue, it would also be important to work toward mechanisms to prevent the cost of supervision from outweighing the overall economic benefits of the sector. Directors encouraged the authorities to keep up the momentum in their efforts to strengthen the mechanisms to combat money laundering and the financing of terrorism. They supported the provision of IMF technical assistance for this purpose, and looked forward to the FSAP exercise, to be conducted later in 2003.

The monetary and exchange rate system operated by the ECCB had generally served the region well in the past, Directors considered, and they noted the ECCB’s high currency backing ratio and comfortable level of international reserves. They cautioned, however, that preserving the exchange rate peg going forward would require sustained fiscal consolidation and a decline in public sector debt, a sound and well-regulated financial sector, and strengthened efforts to increase the region’s competitiveness. Some Directors encouraged the authorities to keep the currency peg under review. The authorities were also encouraged to abolish the floor on savings deposit rates in order to increase the responsiveness of interest rates to liquidity conditions.

Determined efforts to strengthen external competitiveness and achieve sustainable growth were important, Directors underscored. This would require strong wage restraint, and efforts to increase the flexibility of the labor market and enhance the skill composition of the labor force. Directors also highlighted the benefits that members of the currency union would obtain from deeper structural reforms to improve efficiency as they advanced toward greater regional and global integration. They supported the goal of creating an economic union by 2007, and encouraged the authorities to accelerate integration plans that would position the region to take full advantage of the anticipated Free Trade Area of the Americas and facilitate adjustment to the prospective loss of EU trading preferences for key agricultural products. Stronger efforts toward privatization, trade liberalization, civil service and public sector reforms—including pension reform—and improvements in the business environment were also needed, Directors noted. The region would need appropriate technical assistance to support its integration efforts.

Directors underscored the importance of strengthening economic statistics and addressing remaining weaknesses that hamper the quality of economic analysis. Improvement is most urgent in the national accounts and labor statistics, while further efforts are required to improve the quality, transparency, and timeliness of economic data.

West African Economic and Monetary Union

In March 2003, the Board discussed the recent economic developments and regional policy issues with the West African Economic and Monetary Union (WAEMU), which comprises Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo.

The strong economic expansion in the WAEMU region in the aftermath of the 1994 devaluation of the CFA franc had slowed, Directors observed. The continued uncertainties posed by the unsettled political and economic situation in Côte d’Ivoire (the largest economy in the WAEMU), the delayed global economic recovery, and the possibility of high oil prices resulting from war in the Middle East, along with persistent structural and institutional rigidities across the WAEMU membership, weighed on the region’s growth prospects. An early economic recovery and reestablishment of political stability in Côte d’Ivoire would be essential for regional GDP growth to resume at a pace consistent with poverty reduction in the region, Directors recognized. They considered that the WAEMU was at a crossroads: member governments needed to match their political commitment to WAEMU with strong actions to deepen the regional integration process in the face of the serious uncertainties about the economic outlook.

Directors commended the authorities of the WAEMU for the progress achieved in regional integration since 1994, including the establishment of a customs union and an economic union. However, some important regional reforms remained to be implemented. Directors therefore concurred with the decision to extend the timetable for economic convergence of the member states to 2005. They stressed that determined further fiscal consolidation by all the WAEMU members over the next few years would be necessary to meet the ambitious timetable. The strengthening of regional institutions and greater political commitment on the part of member countries would also facilitate the removal of the remaining obstacles to intraregional trade and the creation of a full-fledged customs union and a single market.

The prudent monetary policy of the Central Bank of West African States (BCEAO) had kept inflation low and the coverage of base money by foreign reserves adequate, Directors noted, despite the weakening of economic performance of the WAEMU member countries. They considered that further steps would be required to streamline monetary policy instruments and to improve the functioning of the regional interbank market. They urged the authorities to pursue a more flexible interest rate policy, and to lay the basis for replacing the current differentiation of reserve requirements with a uniform reserve requirement ratio for all members at the appropriate time. The shift: in government budget financing from central bank direct advances to the issuing of securities on the regional capital market was welcomed by Directors, but they noted that for the market to work optimally, close coordination of monetary and fiscal policies across the WAEMU members, as well as strict observance of the fiscal convergence criterion, would be called for. Development of a deep and effective regional capital market would greatly enhance the efficacy of monetary policy, Directors considered.

Directors noted the moderate improvement in the financial position of the WAEMU banking system and emphasized the importance of further improvement. Measures to ensure the observance of prudential ratios by banks, and to strengthen loan recovery mechanisms and the judicial environment, would help to raise the standard of banks’ portfolios. Reinforcement of the authority of the Regional Banking Commission would be essential to ensure the effectiveness of bank supervision and the adherence by financial institutions to prudential norms.

The adoption by the WAEMU Council of Ministers of an anti-money-laundering directive and a draft community regulation on the freezing of funds linked to terrorist activities was supported by Directors, who also urged member states to enforce strictly the relevant laws and regulations.

Directors welcomed the initiatives undertaken in the past few years to harmonize taxation, budget laws, and government accounts, and they noted that these initiatives and the steadfast implementation of the remaining reform agenda will be crucial if the full benefits of economic integration are to be reaped. The authorities were encouraged to pursue the harmonization of exemptions and the adoption of a common investment code, which would help level the playing field and remove residual distortions. Directors welcomed the establishment of structural funds, which should help reduce regional disparities. They also encouraged the establishment of a regional solidarity bank, which should complement rather than compete against the lending activities of microfinance institutions in the context of poverty reduction efforts.

The external competitiveness of the WAEMU economies is so far adequate, Directors agreed, but these economies remained vulnerable to fluctuations in the terms of trade. To maintain the region’s external competitiveness and its share in export markets, Directors recommended policies aimed at broadening the productive base and diversifying the economies, improving factor productivity, and reducing high non-labor domestic costs, along with continued sound macroeconomic policies. The authorities were also urged to pursue regional sectoral policies aimed at addressing the underlying structural rigidities of the WAEMU economies.

The steps taken toward the implementation of a common trade policy by WAEMU members and the encouragement of intraregional trade were welcomed by the Board. A common external tariff (CET) was being set in place in all members. Directors also welcomed the increase in volume in intraregional trade resulting from the internal trade liberalization undertaken so far. At the same time, considerable scope for further liberalization remained, and Directors encouraged the authorities to eliminate nontariff barriers to intraregional trade, as well as the exceptions to the CET.

Directors recalled the decision by the Heads of State of the Economic Community of West African States (ECOWAS) to create a large single regional market, and ultimately to establish a common monetary framework. Achievement of this objective would require a high degree of macroeconomic convergence among the member countries, which at present was lacking. Directors acknowledged the strong political support underpinning the integration process within ECOWAS, and considered that the goal of achieving a single monetary union in West Africa could serve as a useful anchor for economic policy, even though convergence remained an ambitious objective and would take time. Member countries of the WAEMU and the ECOWAS were encouraged to intensify their cooperation in the areas of macroeconomic and sectoral policies and trade in order to set a firm foundation for monetary and economic union at the appropriate juncture.

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