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ON THE WORLD ECONOMIC OUTLOOK
MICHAEL MUSSA, COUNSELLOR AND DIRECTOR
INTERNATIONAL MONETARY FUND
April 13, 1998, 9:00 a.m.
Meeting Hall A
IMF Headquarters Building
MR. ANJARIA: Good morning, ladies and gentlemen, and welcome to the first of a series of events we are going to have for the press in conjunction with the Interim Committee meeting which takes place on April 16. I would like to welcome you to the press conference on the World Economic Outlook being given by Mr. Michael Mussa, Economic Counselor and Director of the Research Department of the IMF. I would like to also mention that tomorrow at this time, 9:00, we will have a press conference by the Managing Director in this same hall.
I would like to introduce Mr. Mussa to my right; Mr. Flemming Larsen, the Deputy Director of the Research Department to his right; and Mr. Graham Hacche, Assistant Director of the Research Department to his right. I would like to invite Mr. Mussa and Mr. Larsen to give introductory comments.
MR. MUSSA: As some of you will recall, for the second time in a decade in December, we issued an interim assessment of the World Economic Outlook primarily to take account of the crisis in east and southeast Asia and its consequences more broadly for the world economy. At that time, we wrote down the forecasts for world growth from a little over 4 percent to 3 ½ percent--3/4 of a percentage point reduction--largely due to significantly lower growth forecasts in a number of Asian economies--the ASEAN-4, plus Korea--which were the countries directly involved in the crisis, and also for Japan.
Since the interim assessment of the World Economic Outlook, as I emphasized at the press conference in December, we have seen the materialization of some of the downside risks that concerned us at that time. We have now revised down the growth forecasts for world growth in 1998 by a further half percentage to just a hair above 3 percent. That downward revision reflects almost exclusively the recognition of lower expected growth in Asia. The growth forecast for the ASEAN-4 and Korea has been knocked down by another 4 percent on average for those five countries, and the growth forecasts for Japan as of the published version of the WEO has been knocked to a flat zero. Given recent data for Japan, it now looks as if zero may be a little bit difficult to materialize, but the fiscal stimulus package announced by the Prime Minister, I think, does offer some reasonable hope that in the second half of the year, at least, we will see some resumption of positive growth, though the first half continues to look weak.
Of course, there will be other countries that will benefit, the oil importing countries among both the industrial countries and developing countries. In those countries, and also in several Asian economies, probably the balance of risk relative to the WEO forecast is on the downside, with upside potential probably in North America and in continental Europe.
With that, let me stop my opening statement and ask Mr. Larsen to say a few words about the other contents of the WEO.
MR. LARSEN: As usual, the World Economic Outlook presents not only a revised assessment of the global economic situation and outlook; it also deals in some depth with a number of special issues that we think are of particular of interest at this point in time for policymakers around the world in helping them to think about the challenges they are facing in their economies. Much of the WEO this time is naturally addressed to the issue of financial crisis, foreign exchange market crisis, and banking crisis. In Chapter 4, we have surveyed a very large number of crises during the past 25 years to try to see if there are some common characteristics of these crises that may allow us to draw some lessons for the future and perhaps even hope to be able to pre-empt future crises.
The conclusions of this analysis are presented in a very cautious fashion. We do think there are some common characteristics, but there are rarely two crises that are absolutely identical and one does need to be alert to the possibility that one set of indicators that may have been useful to capture some crisis may not always be the right indicators to look at in order to prevent future crises. This being said, we do think, and that is the gist of the chapter, that there is some scope for better being able to identify vulnerabilities before crises hit, provided, of course, policymakers are prepared to heed the advice and the consequences that arise from such a discussion and identification of vulnerabilities.
Finally, in Chapter 5 of this WEO, we are looking at some of the fiscal challenges that the countries in transition are still facing. Fiscal consolidation has played a major role in the stabilization gains that have been achieved so far in the countries in transition. But, as we make clear in this chapter, there are still many challenges to be met in the fiscal area if the fiscal achievements and stabilization achievements are to be sustained.
QUESTION: Could you expand a bit about your comments on the transition countries? You keep saying that they have got to get going on reforms and yet your figures for growth are pretty decent, and especially in Russia, where you have downgraded a little bit, but yet you are very strong about tax collections. Could you just comment a bit?
MR. MUSSA: Well, of course, the growth performance of the transition countries is quite different. Poland has been the strongest growing economy in Europe in the past four years. Hungary has done reasonably well, though it slowed down in 1995. The Czech Republic did well for a number of years and then it slowed down in 1997. Slovenia has been doing quite well, also. So, a number of the countries, particularly in eastern Europe and those who started first and pursued most aggressively and in a most determined way their reform policies, have been growing now 3-4 years running.
This is much less the case in the countries that were formally part of the Soviet Union. Russia itself turned to positive growth, barely positive growth, only in 1997. A good deal of empirical work that has been done on this issue does seem to isolate differences in the speed and determination with which reform policies have been put in place as one of the factors that is important in explaining this difference in growth performance.
On the specific issue of fiscal policy, there is a chapter discussing the fiscal challenges, and also in Part 2 in the boxes and Annexes there is a specific box dealing with the fiscal situation in Russia, where the weakness of revenue collection--and particularly collection of cash revenues--by the central government has been, I think, the major source of concern for almost two years now, since just before the presidential election. Over that period, revenues as a share of GDP have continued to decline despite a number of efforts on the part of the Russian government to strengthen revenue collection.
The failure to collect cash revenues is one of the things that has contributed to the system of arrears, where the government itself acquires goods and services but does not pay for them, builds up arrears for wages and for other products, and then people do not pay their taxes anticipating that they can then cut a deal with the government later. This contributes to a systemic problem in the Russian economy in which, quite broadly speaking, contractual enforcement is very poor, and that is not a reliable basis on which to build a market economy. So, the problem is more than just the weakness in the fiscal system in Russia; it also is interfering in a very serious way with the performance of the economy overall.
QUESTION: Mr. Mussa, two questions, one on Japan and one on EMU.
On Japan, you said that zero would be hard to achieve, if I heard you correctly. The OECD said Japan was poised on the brink of recession last week. Is it the IMF's view that the first two quarters of this year will see a recession, meaning contraction? What do you mean when you say zero will be hard to achieve? Do you mean there will be a contraction? That is the Japan question.
MR. MUSSA: Let me deal with Japan. I think I am going to ask Mr. Larsen to deal with the EMU question.
During 1997 in Japan, the first quarter was fairly strong in anticipation of the consumption tax increase. But if we take the four quarters of 1997, domestic demand in Japan over those four quarters fell almost 2 percent. So, in terms of domestic demand, there was a recession in 1997. The net export position of the Japanese economy improved in 1997, so over the four quarters GDP was probably down very slightly. We do not know for a fact; we will need to see the final revisions on that.
During the first quarter of this year--and we do not yet have the data--it looks as if GDP was down. Certainly, consumption was very weak. Industrial production for February was very weak after January gains. And looking forward, producers were saying they were projecting further output declines. The Tancan Survey released a couple of weeks ago suggested that the second quarter, at least as far as Japanese business was concerned, was likely going to be another down quarter.
So, it does look as if during the first half of the year we are looking at GDP headed downward. Now, it remains to be seen what the final outcome will be. Trade balance figures for February announced just today showed a further increase in the surplus, notwithstanding loss of exports to the rest of Asia. So, probably the Japanese economy contracted in the first quarter and will probably contract somewhat further in the second quarter.
The fiscal stimulus measures announced by the Prime Minister will not be enacted until later this spring and will not begin to affect the Japanese economy in any direct way--there may be effects on confidence--until sometime this summer. Now, those measures will impact the economy primarily in the second half of this year and first half of next year, and they should add to domestic demand growth in Japan something like 1 ½ percentage points of GDP. That takes account of the fact that tax cuts will be a little bit less powerful than the spending increases. We believe that that will be sufficient to turn domestic demand from negative growth to at least slightly positive growth.
Our assessment is that, while Japan is losing export competitiveness vis-à-vis the rest of Asia, it is enjoying very strong competitiveness vis-à-vis North America and Europe, which will continue to be fairly rapidly expanding economies. So, we think that Japan can turn from negative growth in the first half of this year to slightly positive growth in the second half of this year, and then perhaps picking up some momentum in 1999. To sustain that momentum, however, it will probably be necessary to extend fiscal support beyond the second half of this year and the first half of next year until it is clear that domestic demand in Japan is on a self-sustained basis.
QUESTION: What do you mean? Do you mean other measures beyond the $75 billion package?
MR. MUSSA: Well, the $75 billion package covers primarily fiscal year 1998. So, if the Japanese government were then to revert to the old fiscal plan, we would have a substantial withdrawal of fiscal stimulus in fiscal year 1999. Now, it may be feasible in fiscal year 1999 to reduce somewhat the degree of stimulus that is being added now, but if you put in 2 percent of fiscal stimulus this year and you take out 2 percent next year, then you may well simply resume the problem. So, there will need to be some meaningful amount of fiscal stimulus above and beyond the existing medium-term plan unless there is some strong reason to believe that the Japanese economy will resume on its own a fairly powerful pattern of growth.
Now, we do anticipate that the crisis elsewhere in Asia will reach its peak this year and that probably by late this year most of those economies will begin their recoveries, and the bounce-back could be fairly rapid after a very steep decline. That is what happened in Mexico and in Argentina. So, Japan could get some help from that. Japanese recovery itself could help the rest of Asia. So, there is some potential for the expansion in Asia to build on its own momentum. It still would probably be unwise to plan a large withdrawal of fiscal support as early as 1999.
QUESTION: EMU question for Mr. Larsen. Two things on EMU. One, in your report, you mention that the failure to reform labor markets in Europe is the Achilles' heel of the EMU project. I wonder if you could speak to that and explain in more detail what you mean.
Also in your report, you look at deutsche mark interest rates going up to 4.5 percent in 1999 and 3.9 percent in 1998. Does that mean you can tell us today what your view of the first initial rate of the euro will be? The consensus in Europe is about 3.8 percent. Is the IMF prepared to say that? And are you suggesting that Germany will have to raise interest rates above that level in 1999 after EMU starts; is that what this means?
MR. LARSEN: First, on the Achilles' heel, yes, this is indeed the description we are using in the World Economic Outlook about the state of European labor markets. First, briefly, on the macroeconomic criteria. You will see estimates in an appendix to Chapter 1 which broadly are consistent with the estimates that have been put forward recently by the European Commission and the European Monetary Institute in terms of the degree of convergence that has now been achieved. It does indeed seem likely that the 11 countries that are aspiring to participate at the outset will be deemed to qualify based on the macroeconomic criteria.
This being said, even though there has been substantial progress in the fiscal area, there is still no reason for complacency. It is true that during the period ahead, if indeed, as we think, growth will be picking up in Europe, well then fiscal revenues will be picking up and this will help to contain the actual, the nominal budget deficits. But, if we look at what is happening in terms of the structural budget deficit positions--which you will remember is a concept that we are particularly looking at here at the IMF, because that adjusts the actual budget deficits for the effects of the economic cycle--and if you look at Chart 4 on page 26, you will observe there a small and ever so slight tendency for the structural deficits to begin to widen slightly in a number of EU countries in 1998 and 1999. This is not such a sharp widening that is a major cause for concern, but it is clearly going in the wrong direction. It illustrates that there is still quite a bit to be done in terms of continuing the process of fiscal consolidation and consolidating the achievements that already have been made.
The labor market issues, we think, are also extremely important for the success of the monetary union, and we discussed that quite extensively last October when we had a full chapter devoted to EMU. This time we mainly summarized the results. The basic point to be made here is that, in the absence of an exchange rate instrument that countries can use when they are subject to exceptional disturbances, be it domestic or from outside, in the absence of such an exchange rate instrument the demands on the ability of the labor market to absorb such shocks are much greater. This is precisely the big difference there is between the United States economy, that also functions very well with a common currency, and the countries of the European Union, where labor markets in most cases are much less flexible.
This is not something that is going to cause difficulties immediately for the monetary union. There is still plenty of time to address these problems. But, in the future, when the European Union countries experience the types of shocks that they have experienced in the past, they could run into difficulties if their labor markets do not become more flexible. Such difficulties would show up in the form of higher unemployment rates in some countries or regions, and, of course, increased pressures on the fiscal positions, on fiscal revenues and expenditures. So, this is clearly something that does need to be addressed, and the sooner the better.
On the interest rate forecast, well, as you will see from our interest rate assumptions that are spelled out in a box also, we usually assume that monetary policy and, therefore, interest rates, are not accommodating. With a relatively solid economic recovery we are projecting for Europe, we are obviously assuming some firming of monetary conditions, not a sharp rise in interest rates but some firming. This is the pattern that we have seen in the past and is also the pattern we will expect for the future, even though we do not see a great rush about the need to raise interest rates at present given that domestic demand in some European countries, including Germany, still has not picked up quite as much as one would like.
What would this mean for the future exchange rate of the euro? Well, we obviously do not make a forecast of what the euro exchange rate is going to look like. But, keep in mind the lessons and conclusions we draw in Chapter 3 about the influence of the economic cycle. If, indeed, we are now going to see a pickup in Europe and a slowdown to a more sustainable growth rate in the United States, then we would tend to see this greater convergence of cyclical positions that we discussed in Chapter 3. Presumably this might be one factor, among several others, that would influence exchange rates. These factors, looking at them in isolation, will probably tend to suggest a tendency for the euro to firm somewhat against the dollar during the next couple of years. But it is impossible based on this analysis to say how much it would firm.
QUESTION: Two related questions, please, Mr. Mussa. First of all, on page 99 of the report, you talk about the current constellation of exchange rates among the major currencies. Could you explain to me, please, what you are talking about when you talk about until very recently the weakness of the deutsche mark was consistent with cyclical conditions? Do you mean that until recently the deutsche mark was weak, or that until recently there were cyclical conditions which contributed to this weakness and, if so, what has changed recently to change your outlook on that?
Then on page 4 you talk about the vulnerability of the dollar to changes in sentiment. Because of the relative economic cycles, everyone expects the U.S. trade and current accounts will deteriorate this year. Can you talk about what you think the chances are that there will be a change in sentiment?
MR. MUSSA: First, with respect to the deutsche mark, there are really two points about consistency with relative cyclical positions. One is that vis-à-vis where we were some months ago, there is a general indication now that recovery is somewhat stronger, not so much in Germany but, more broadly, in continental Europe. As it becomes, I think, increasingly likely that we will see EMU start on January 1, 1999, the cyclical conditions that are relevant to the exchange rate of the currency, of which the deutsche mark will be a non-decimal component, those cyclical conditions now look a little bit stronger than they did a few months ago. That would be a fact that would tend to strengthen the euro and, hence, all the currencies that would participate in it. So, vis-à-vis where we were a few months ago in terms of relative cyclical positions, we would see somewhat less reason for weakness of the deutsche mark versus the dollar.
We actually see the deutsche mark is somewhat weaker versus the dollar than it was some months ago, so developments over the last few months have not been quite as consistent with the relative cyclical position story as where we were a few months ago, because that would suggest perhaps we would be seeing a little bit stronger deutsche mark and other European currencies against the dollar; instead, we have seen a little bit weaker. But I do not want to push that argument too hard at this stage of the game. As Mr. Larsen suggested, on balance, we would think probably that we will see some strengthening of the European currencies against the dollar as we move forward over the next three or four years.
Against the yen, however, the situation will be a little bit different. There, the yen, of course, has been very weak recently because of the extraordinarily weak cyclical situation in Japan. As that normalizes, we would anticipate that the yen might strengthen, again looking over a horizon of three or four years.
Regarding the dollar and how changes in sentiment might affect the dollar, our forecast is that the U.S. current account deficit will rise to about $230 billion dollars this year, 2 3/4 percent of GDP, again reflecting both the strength of the dollar and the strong performance of the U.S. economy, both of which tend to worsen the current account position of the United States. Now, a deficit of that size is not worrying as a one-year or two-year phenomenon, but the savings-investment balance of the United States has been improving as the fiscal deficit has come down. It is reasonable to anticipate in the medium term that the equilibrium position for the United States would be with a current account deficit smaller than 2 3/4 percent of GDP, and that would suggest that the real net foreign exchange position of the dollar might plausibly be somewhat weaker than it is at present.
Now, if that is a reasonable expectation, the question is how might that change come about? We have observed in some past occasions that currencies strengthen and then gradually weaken. We observed in other instances that currencies strengthen and then weaken all at once. It is difficult to foresee at this stage which of those scenarios is really the most likely. One of the concerns we have, which might lead to a stronger dollar in the near term, is we see some evidence that underlying inflationary pressures are picking up a little bit in the U.S. economy. Wages are rising a little bit more rapidly than they had been in recent years.
The buoyancy in asset market prices is certainly visibly apparent in the stock market, but also in recent months seems to be spreading to the real estate market as well. It is possible that if the U.S. economy does not slow down on its own, that some time later this year or early next year the Federal Reserve will need to make monetary conditions somewhat firmer. We have observed what has happened as the Bank of England has done that in the U.K. in 1997, and it is one of the factors that has contributed to additional strength of the sterling. We might see that also as a possible scenario in the United States.
In those circumstances, we might see then for a while a further weakening of the U.S. current account position, and then the danger that if the U.S. economy slowed down a lot we could see the dollar move sharply lower relatively suddenly becomes a relevant scenario to be at least thought about by the international community and by the policymakers who are responsible for coordinating macroeconomic policies within and across national boundaries. Again, this is a scenario; it is not a forecast of The single most likely event. But it is a possibility that warrants some concern at this time.
QUESTION: On page 4, where you refer to the dollar, you also almost in throwaway lines suggest that sterling might be in the same position as the dollar. I wonder if you could enlarge on what your analysis is about sterling, and whether you think there is a safe-haven effect as far as EMU is concerned which has given sterling its surge in recent months or over the last 18 months, really.
MR. MUSSA: Well, we have seen sterling appreciate over the past year to its strongest position on a real effective basis in this decade and the evidence increasingly points to the impact that this is having on the manufacturing sector, the tradable goods sector in the United Kingdom, with that sector seeing now some declines in output, while the service sector, which is relatively more sheltered from exchange rate influences, continues to perform very strongly in the United Kingdom. So, we have a kind of bifurcating economy, with the overall economy continuing to grow moderately strongly but with considerable weakness in the manufacturing sector.
Now, I recall in the middle of the 1980s we used to talk about the "rust belt" in the United States, and that is how the manufacturing industries in the Midwest and the east AND north central regions of the United States were suffering from the consequences of the very strong dollar while the economy overall was continuing to perform reasonably strongly. It looks like that type of phenomenon is affecting the United Kingdom at present.
Now, of course, at that time the dollar was really extraordinarily strong, and by early 1985 there was a broad consensus that it really substantially overshot the mark and a significant downward correction was, therefore, both needed and desirable. In the case of sterling, the extent of the appreciation is considerably less extensive than the dollar in the middle 1980s. But I think there is again in the case of the U.K., and probably to a greater extent than I would expect it for the U.S. at present, some expectation that over the medium term the value of sterling probably will correct downward against continental European currencies.
When exactly that may begin to happen, however, is not clear. I recall forecasting with confidence in December of 1992 that the dollar was too strong and would probably come down, and forecasting in December of 1993 that the dollar was too strong and would have to come down, and forecasting in December of 1994 that the dollar was certainly too strong and would have to come down, and finally the market got it right!
QUESTION: You said that maybe money has come into sterling because of uncertainty surrounding the start-up of the euro. I wondered if you felt that would have been a factor in sterling's strength in recent months.
MR. MUSSA: It is possible that it is a factor, but I would doubt that it is the predominant factor. There was some earlier strengthening of the Swiss franc on safe-haven concerns, so I would not exclude it entirely. But I would not see it as the dominant influence.
QUESTION: If we look at page 30 of the main report, if we look at the chart on the newly industrialized Asian economies, I see that for this year the IMF forecasts the four Asian tigers will post real GDP growth of 1.8 percent, which I believe is the lowest since World War II and it is the first time that the four tigers will post a GDP growth averaging lower than world output. So, there has been a lot of discussion over the past months in the United States whether the Asian miracle has ended. Can you touch a little bit upon that?
My second question is a little scenario. Yesterday the new Taiwan dollar, Taiwan's currency, experienced the biggest one-day depreciation in nine months, mainly because there is a rumor in the market that China will conduct a new round of military exercises at the end of this month. So, in the IMF, how do you evaluate that military tension, if there is any, across the Taiwan strait will have an impact in the region since Taiwan is not a member of the IMF? So, do you in the IMF have any kind of mechanism to foresee the kind of danger that Taiwan might have that will have regional ramification?
MR. MUSSA: When we speak of the Asian tigers, that term traditionally refers to four economies--Korea, Singapore, Hong Kong, and Taiwan Province of China. The growth forecast for those economies of 1.8 percent is the lowest that we have seen in some time. It is, however, well to recall that Korea at the beginning of the 1950s had some military difficulties of its own, which had a somewhat depressing effect on output. So, I am not sure it is the lowest since the second world war--but in quite some time.
Two things fundamentally are going on. One is that as those economies have matured and we have advanced all of them to the list of advanced economies, as they have caught up with levels of productivity in the industrial countries, it has been reasonable to expect that their growth rates would slow down on a longer-term basis. So, apart from the Asian crisis we would not be expecting that over the next two decades these four economies would turn in the same type of growth performance that has characterized the last three decades. A reasonable expectation could be 5 percent growth rather than 8 or 9 or 10 percent growth. In 1998, most of these economies are feeling the effects of the Asian crisis, both directly in the case of Korea or indirectly from the spillover in competitiveness affects which is the predominant story in Hong Kong, Singapore and Taiwan Province of China.
With respect to the impact of military tensions, we have not paid a great deal of attention to that issue. I would note, however, that we have observed military tensions off and on in various parts of the world and they do not always have a predictable impact on exchange markets.
QUESTION: There has been talk in Russia about devaluing the ruble. Does the IMF believe that such a devaluation could help Russia to solve some of its problems?
MR. MUSSA: The important point is to maintain an exchange rate policy that is consistent with the other macroeconomic policies being pursued by a government and with its evolving international competitiveness position. The exchange rate policy pursued by the Russian government has been an integral part and a very important part of its monetary policy. Monetary policy has really been the key area of success in terms of Russia's macroeconomic policy. It has succeeded in bringing the inflation rate down to less than 1 percent per month. Sustaining that accomplishment and the confidence that it helps bring is something that is very important for the Russian economy. The combination of exchange rate and monetary policy, I think, needs to support that critical objective.
That being said, maintaining a precise value or precise band for the exchange rate is not absolutely essential. But this is probably not a circumstance where the Russian authorities could say, well, we are going to leave it to the market to determine completely the foreign exchange value of the ruble. Russia relies on capital inflows to help finance its budget deficit. It needs to provide some reasonable assurance that the foreign exchange market will not become a source of uncontrolled instability for both domestic and foreign investors.
QUESTION: Mr. Larsen described how the WEO examines the typical features leading up to a financial crisis and derives vulnerability indicators from that. I was wondering in the light of that analysis in which countries does the need for precautionary measures now seem most urgent.
MR. MUSSA: Well, if you were a boy scout, you know "be prepared" is a good motto, and I think that applies in this circumstance as well. We have seen over the past six or eight months a quite dramatic demonstration--not a unique demonstration because we have seen it before--of what can happen to an economy when foreign and domestic investors suddenly lose confidence in the economy and economic policies. The consequence can be a very disruptive and costly crisis that is not only a financial crisis but also a crisis for the real economy.
Now, to some extent, the causes of these crises are events that no one can control. One of the problems that Indonesia is facing, and it is not the only one, is not economic but it is the weather. It is El Nino. Well, El Nino is a problem but we do not have really a way of controlling it. There are some events in world financial markets that also have the characteristic of El Nino. Investor sentiment changes from being overly buoyant and overly supportive, pouring capital into a country, to suddenly a shift where doubts arise and people want to yank their capital out. That is a very disturbing thing for an economy to undergo.
Often times domestic economic weaknesses are a key factor in motivating that change of sentiment, but they are not the only factor and certainly have not been the only factor in Asia. It is a characteristic of the way in which market-oriented capital markets do tend to behave. And when I tell the story of what is to be done about this, I say, well, I knew about this long before I became an economist. I knew about it when I was very young child and learned about the three little pigs and the big bad wolf. The moral of that story is you need to build a brick house in order to be able to withstand the huffing and puffing of the big bad wolf. So, there is key message there for most of the economies around the world, that your economic policies and your financial institutions need to be sufficiently strong so that if the big bad wolf comes huffing and puffing, you can survive the incident.
What we have seen, I think, in the past year is a dramatic demonstration that those countries that have been able to and prepared to and have responded fairly aggressively when the pressures have come--and this has been true in Brazil, it has been true in Russia, true in the Czech Republic after an initial devaluation, have been prepared to tighten policies to raise interest rates and to do the other things that are necessary to withstand the pressures of the crisis--they have done significantly better than the economies that have either been unable or unwilling to respond in that way.
Now, I say "unable," because one of things which makes it very difficult for a country to be able to tighten its monetary policy in particular when pressures arise in international capital flows is having a very weak financial system. That is why in the Fund programs for the countries in crisis we have laid such heavy emphasis on structural reform in the financial system.
So, are there countries that need to worry about this issue? Yes, absolutely. But I am going to keep the list to myself at the present time. I will allow all of you, gentlemen, to speculate on who they might be, or actually yesterday, as I was walking around on my Easter walk, I happened to walk on Wisconsin Avenue. As I was walking past the gymnasium, there was Rudy Dornbusch, my old friend--a graduate school colleague. You could ask Rudy what he thinks; he seems to find lots of countries where crises might be forthcoming.
QUESTION: In your Chapter 4 discussion along these lines, just in general, what is the relative weight the IMF gives in terms of the origins of the crisis to the systemic instability of capital flows, and how much merit are you giving now to short-term capital controls or prudential regulation to slow down inflows into the developing countries?
MR. MUSSA: It is usually the two things together that are the fundamental source of difficulty. It is when weaknesses in the financial system or in the real economy, weaknesses in economic policy, including an incapacity of policy to respond forcefully to pressures, it is when that combines with the pressures that you get the crisis. The instability that we observe in capital markets more generally and in international capital flows in particular is, as I suggested, something like El Nino. It is the weather and we cannot control it.
It does not mean that we cannot influence it. But the key aspect is making sure that the institutional structure and the structure and responsiveness of economic policy is sufficiently robust that when the pressures come the damage can be limited. So, we saw pressures against the peg of the Hong Kong dollar, but a very robust financial system--capital and real capital in financial institutions in Hong Kong double the Basle standard, very large foreign exchange reserves, a very determined monetary authority capable of withstanding those pressures. But they need that kind of strength to sustain that type of system, because sometimes the pressures do come and they are not always of your own making. If those pressures come and your economy, your institutions and your policies are weak, that is when you get into big trouble.
QUESTION: Is the IMF now favoring capital controls?
MR. MUSSA: Well, the issue is what is a capital control? And there are lots of them. One of the problems is that in Korea we had controls on capital which discouraged inward equity investment, which discouraged long-term borrowing by domestic corporates, and which encouraged short-term borrowing denominated in foreign currency intermediated through the banking system. That is an exceedingly dangerous form of finance.
In Thailand, before the crisis, there was $35 billion of short-term foreign currency debt, most of it intermediated through Thai financial institutions. So, they had a net foreign exchange exposure short term of about $35 billion. Now, if we scale up to the size of the U.S. economy, how much would that exposure be in US terms? About $2 trillion or about DM 3 trillion. I just saw Alan Greenspan walk into IMF Headquarters this morning to get his tag. Now, if U.S. financial institutions had a net exposure of DM 3 trillion, Alan would be a bit worried. Hans Tietmeyer would be a bit worried, too, because somebody would be on the other side of that enormous risk.
So, I do not regard it as a capital control that a country like Thailand should seek in its prudential regulations to avoid a circumstance in which its financial institutions are exposed to that magnitude of foreign exchange risk. Protecting the economy and the financial system against that type of risk is not a capital control; it is a prudential regulation. We in the IMF want to see government policies, supervision of the financial system managed in such a way that that magnitude of risk is not created as a consequence of their international transactions situation.
In the case of Thailand, as in Korea, part of that problem was that the Bangkok international banking facility really encouraged this form of capital flow. So, it is not just a matter that controls are good or controls are bad. Prudential regulations that protect against imprudent risks are a good thing. Capital controls that create or help to create these enormous risks are a bad thing.
QUESTION: On page 69 there are the projections for 1998 of the fiscal balance in Argentina, and I see that there has been a correction; it was minus 2.3 and it has been corrected to minus 1.4. I wanted to know why, first. The second question is, as you know, there was this mission from the Monetary Fund that went recently to Argentina and gave several recommendations to the government due to this growing trade deficit. The government has said that they are not going to implement the recommendations of the Monetary Fund. I would like to know how serious could it be if these recommendations are not implemented, and what could be the impact on the program we have with the IMF?
MR. LARSEN: First, on the corrigendum that you have received, there is a page that has some revised fiscal numbers. This correction was to correct an error that has sneaked into our database. We are trying to find out exactly what happened. There is no particularly interesting story behind it; it was simply a mistake. The numbers you now have are the correct projections that we actually had in an earlier document that for some reason was changed here.
On the state of the discussions between the Fund and the Argentine authorities, I cannot really comment on that. Obviously, the Fund is doing its best to advise all member countries about the policies that they should pursue in their own best interest to achieve high rates of sustainable economic growth and reduce their vulnerability to the kind of events that have happened in the world in recent years. I am sure that the discussions will continue to focus on getting the best set of policies in place also in Argentina.
QUESTION: On page 17, you suggested that the reforms in India lost steam and that will require more vigorous reforms. I was wondering whether you could elaborate on that. Secondly, there seems to be considerable confusion about the mantra of fiscal consolidation. Like all mantras, you get different high priests who interpret it in different ways. The question is whether when you say fiscal consolidation you mean only the central budget or also the central budget plus the state deficits, plus the deficits incurred by the state-owned corporations. I think clarification may help very much.
MR. MUSSA: The substantial concern is not just with the central government budget deficit, but, as you suggested, with the overall fiscal situation of the government sector, plus the state enterprises. If we look at the so-called quasi-fiscal deficit, which includes all of those elements, then some estimates, because it is difficult to get a precise number, push that figure up to 9 or 10 percent of GDP, which is a very large number. Granted, the same concept applied to other countries also expands in most cases the estimates of fiscal deficits for other countries.
In the case of India, where we have a large state enterprise sector and significant deficits also at the regional level, the problem is a very important one. There is certainly some sense that, aside from the fiscal area, the structural reform which proceeded quite in the early years of this decade has in the last year or two slowed down some. So, it is necessary to move both on the fiscal front and on the structural front. And as much of the economy is still controlled by state enterprises, which are also an important source of the problem of the quasi-fiscal deficit, the structural reform and the fiscal consolidation are clearly related elements.
QUESTION: My question is on monetary policy in the EMU countries on pages 13 and 30. Your projections on page 30 assume that the repo rate will be hiked this year about 50 basis points, from 3.4 to 3.9, and then the next hike in the European sector bank next year to 4.5. What is your assumption regarding the convergence of monetary policy until the end of this year?
MR. MUSSA: Well, as Mr. Larsen suggested, in response to an earlier question, in our projections for interest rates we assume that there will be a kind of normal response of monetary policy to what we anticipate will be a strengthening economic recovery in continental Europe generally and also in Germany. That is the projection. Policy, however, is made each week or each month by the Bundesbank Council in light of how they see developments at that time and looking forward. Given the information we have right now, even though we anticipate that sometime later this year probably it will be appropriate to make interest rates a little bit firmer, we have not yet reached that point. It is possible we will not reach it.
On the other hand, it is also possible that the economy will strengthen a great deal more than we are anticipating or that other considerations which would lead to a faster tightening of monetary conditions would arise. But monetary policy is not something where you make it in the middle of April and fix it for the next year or two years. So, for the time being at least, we think it remains appropriate to keep short-term interest rates where they are. But, if the economy strengthens, as we expect it to, then some place along the road some firming of monetary conditions will become appropriate.
QUESTION: You discussed that the downside risks centered around Asia. Could you elaborate on what risk you see there, the major risk there that the 3 percent forecast that you are now forecasting will not come about?
MR. MUSSA: Let me emphasize that there are risks everywhere, and risks exist both on the upside and on the downside. I think given our present forecast that the balance of risk is probably still for Asia a little bit more to the downside, though I think we have got most of it in the present forecast, because we do have negative growth forecast for Korea, Thailand, and particularly for Indonesia.
There is some risk that I think, on balance, the forecast probably should be a little bit lower than they are now, because they are about minus 1 for Korea. It looks very weak in the first half of this year. And while I think the turnaround will come this summer or this fall, that is not yet clearly apparent. Thailand, I think, will follow a similar path. In the case of Indonesia there remains very great uncertainty at this time, and it is simply too early to perceive when the turnaround for the real economy might come.
So, the economies that are sort of at the heart of the crisis, there is some worry there; that is one concern. The Japanese economy is another source of concern. There, it is really the weakness of consumer and business sentiment which has been driving the economy down. Fiscal policy can help to provide some undergirding, but it is very difficult to know precisely what you can do to turn sentiment around. So, that is a challenging task. Until we see some evidence, more evidence that that is actually happening, we are concerned that the balance of risk may still be on the downside for Japan.
Now, of course, there are risks elsewhere in Asia. We talked about India earlier. China, our growth forecast is for 7 percent, which would be the lowest growth that China has had in some years. The Chinese authorities are expecting 8. There is obviously uncertainty around that forecast as well. But in contrast to what I said in Hong Kong in October and here in December, where my characterization for Asia was that the risks were decidedly on the downside, I think now that while the balance of risk remains on the downside for Asia, that that risk now seems to me to be reasonably well contained, though we probably are still a little on the optimistic side for Asia.
Now, I want to emphasize I think that that is counterbalanced by risks that probably are on the upside for continental Europe. Of course, I thought that a year ago and it did not materialize. There is considerable uncertainty that surrounds any forecast at this stage. Looking ahead to 1999, there would be other risks that one would want to be concerned with, how much will the U.S. economy will slow; if it does overheat, will the Federal Reserve have to tighten; and what would be the consequences of that for other economies around the world. Again, there is no reason to anticipate a severe tightening at this stage, but it remains something you would worry about if you are looking out beyond the next 6-9 months, depending on how the U.S. economy evolves.
QUESTION: Just sticking with the risks to the outlook specifically for the U.S. for a moment here, you do mention the risk of significant correction to equity prices on page 4. How realistic do you think that occurrence is? What is the risk of a major correction in equity prices here and what could trigger it?
MR. MUSSA: Well, most measures of valuation, if we look at price-earnings ratios, we look at dividend yield ratios, indicate that equity prices in the United States now are at or very near historical peaks, and traditionally markets have found it very difficult to sustain these levels over longer periods of time.
Now, it does need to be emphasized that earnings growth in the United States has been very strong in the 1990s, and a good deal of the increase in equity prices which we have seen in the United States has a strong undergirding of stronger corporate earnings. But the multiple over earnings does seem to be getting to relatively lofty heights. Now, there may be factors such as desire to accumulate retirement provisions, and so forth, which are motivating investments in common stocks and reducing the required equity premium that will support a higher level of valuation in the longer term. But, there is a concern.
Now, what would be the consequences if we had, say, a 20 percent correction? I think for the U.S. economy, mild. We saw that experiment run with the stock market crash of 1987. It caused a brief pause in the demand growth in the U.S. economy, but did not do a great deal of prolonged damage. So, while I think there needs to be a concern about the possibility of an equity market correction in the United States and possibly also in a number of European equity markets where prices have run up also quite substantially, particularly over the past year, I do not think there is reason at this stage to fear that there would be large adverse consequences from such a correction.
Of course, if a downward correction became uncontrolled, then there would be more of a source for concern. But, the monetary authorities in the United States have plenty of latitude to ease policy in circumstances where it looks like the economy might be slowing down very substantially or turning into recession. The strength of corporate earnings and the underlying strength of the U.S. economy are such that, while it may be reasonable to worry about a moderate stock market correction, there does not appear to be a strong reason to fear that we would see the market go from 8,000 to 4,000 at this stage, which would be more of a worry in terms of what its medium-term consequences might be.
I would also add that in the case of the United States, and this is also true in Europe, we have seen no big run-up in real estate values as of this stage. The financial system is not significantly exposed to equity markets in the United States. Banks do not hold equities; they are not part of their capital base and any margin lending is very well protected. So, there is at this stage at least no significant danger of a Japanese-type problem where, when you had a correction in the equity market, also a big correction in the real estate market, and then that has been a continuing burden on the financial sector for much of this decade. The U.S. economy is not positioned in that way, and the financial system is very healthy at this time.
IMF EXTERNAL RELATIONS DEPARTMENT