1998 IMF Survey Supplement on the Fund / September 1998

Response to Financial Turmoil

IMF Acts in Changing Economic Environment
To Strengthen Global Monetary System

IMF First Deputy Managing Director Stanley Fischer (left) and IMF Managing Director Michel Camdessus respond to questions during a press briefing.
The increasing globalization of financial markets has created a vast pool of resources for investment, economic growth, and social advancement. At the same time, as is evident in the financial turmoil that erupted in southeast Asia in mid-1997 and the crisis affecting Russia in 1998, it has brought increased risk—the risk that capital flows will dry up or reverse as market confidence falters. The international reverberations of the Asian crisis—characterized by plunging exchange rates and equity prices—were probably the most far-reaching of the postwar period. The crisis first broke out in July 1997 in Thailand when, following several episodes of exchange market pressure and reserve losses, the authorities abandoned the peg of the baht to the U.S. dollar. This action, in turn, raised doubts about the viability of exchange rate arrangements elsewhere. Spillover effects were soon felt in other countries in the region, especially Indonesia, Korea, Malaysia, and the Philippines, and exposed underlying structural weaknesses in these economies. Growth in Japan also turned negative in late 1997 and the first half of 1998, which intensified market pressures.

The widespread crisis has dominated the work of the IMF over the past year, prompting IMF lending to reach record levels and placing considerable strain on its financial resources. This has added urgency to the need to strengthen the institution’s resources through a quota increase and other measures, so that it can continue to play its full role in the world economy.

Developments in the World Economy

The Asian financial crisis contributed to a slowdown of global growth in late 1997 and 1998. For 1997 as a whole, world output growth continued at about 4 percent, as slower growth in Africa, Asia, and the Middle East was offset by faster expansion in most industrial countries (other than Japan), the developing countries of the Western Hemisphere, and several countries in transition. With the recession in Asia deepening and broadening in 1998—even while there was significant progress with macroeconomic stabilization in the original crisis countries—the risk of setbacks with renewed contagion effects in other emerging market countries increased.

In August, following an intensification of financial pressures in the preceding weeks, the Russian authorities announced a number of emergency measures, including a de facto devaluation of the ruble and a unilateral restructuring of ruble debt. These actions contributed to the most severe wave of international financial instability in recent months, including a marked increase in the cost of funds to emerging market economies generally and steep declines in equity markets worldwide. Even with growth in most industrial countries except Japan remaining robust, it now seems that global growth in 1998 will be little more than 2 percent.

Once the Asian crisis began, a redirection of financial flows toward mature markets, together with prospects for lower inflation, contributed to strong declines in medium- and long-term interest rates in the industrial countries in late 1997 and early 1998. This easing of financial conditions, particularly in North America and Europe, supported the growth of domestic demand. Helped by weak primary commodity prices, including those for oil, consumer price inflation in 1997 declined further in each of the main country groups. In 1998, commodity prices have continued to fall, in part as a result of reduced demand in the crisis countries, which has led to sizable losses of export earnings for commodity-exporting countries.

The impact of the Asian crisis on the advanced economies has varied. While the dampening effects of the crisis have helped contain inflationary pressures in some countries that faced the risk of overheating, they have had a large adverse impact on Japan, where economic activity and confidence were already weak. Downside risks continue to threaten many countries, including Japan, where policy uncertainties remain. The advanced economies of North America and Europe have been less affected by the turmoil in Asia; the robust growth of the U.S. economy and the strengthening expansion of domestic demand in much of western Europe have provided support for global growth in the face of the crisis. In Europe, while the budgetary consolidation and inflation convergence of recent years have laid a firm foundation for European Monetary Union at the beginning of 1999 and have underpinned growth, the members of the euro area will face a number of challenges, including the need to promote greater labor market flexibility.

Financial markets in a large number of developing countries have suffered the effects of the crisis, which have aggravated other problems that limit growth, such as loss of competitiveness, lower commodity prices, and domestic and external imbalances. While the economic slowdown in 1997 was significant in Asia, it was even more marked in Africa, partly owing to a number of temporary factors. In the developing countries of the Western Hemisphere, in contrast, growth in 1997 was actually stronger than in the previous two years, but it weakened in 1998. For the developing countries of the Middle East and Europe, the direct spillovers from the Asian crisis have been generally limited, although the effects through financial and commodity (including oil) markets have been significant in many cases.

Russia and the other transition countries as a whole recorded positive growth in 1997 for the first time in eight years. However, the situation has changed markedly in 1998, as negative spillovers from the Asian crisis became more apparent in financial markets, especially in Russia, Ukraine, and, among the Baltic countries, in Estonia. In Russia, the ruble came under attack on numerous occasions in late 1997 and 1998. Despite an external current account close to balance, pressures arose from a persistently weak fiscal position resulting from poor revenue collection; concerns about how the external position might evolve, if the fiscal imbalance was not dealt with; and the decline in oil prices. Following the August measures, the ruble depreciated steeply through early September amid political uncertainty. A number of transition economies in central Europe, including the Czech Republic, Hungary, and Poland, weathered the crisis reasonably well.

The IMF in 1997/98

The crisis and its subsequent reverberations dominated the IMF’s work in 1997/98. While seeking to limit the risk of moral hazard, the IMF provided unprecedented assistance to contain the damaging consequences of the crisis. Lending reached a record level, as members drew more than $25 billion in IMF credit, bringing total credit outstanding to more than $75 billion. At the end of 1997/98, 60 Stand-By, Extended, and Enhanced Structural Adjustment Facility (ESAF) Arrangements were in effect with member contries. The pressing needs of member countries led, in December 1997, to the creation of the Supplemental Reserve Facility, which is designed to provide financial assistance to member countries with exceptional balance of payments difficulties due to large short-term financing requirements.

Strengthening the International Monetary System

Strengthening the Architecture of the
International Monetary System
Since the Mexican financial crisis of 1994/95, the IMF has adopted several initiatives to strengthen the international monetary system. These initiatives have included more continuous and candid surveillance in general, more intensive surveillance of financial sectors of member countries, closer monitoring of developments in capital markets, and greater emphasis on members’ dissemination of information both to the IMF and to financial markets.

The financial crisis in Asia, however, made it clear that to meet the challenges of a global economy and global financial markets, more far-reaching measures were needed to tackle weaknesses in financial systems, prevent the emergence of inappropriate external debt profiles, and ensure greater transparency in both public and private sector activity. Successful implementation of these measures will involve not only the commitment of individual countries but also broad-based cooperative efforts of the entire international community.

At a meeting in April 1998, the IMF’s Executive Board, reflecting on lessons learned and drawing on earlier discussions, identified a series of approaches for strengthening the international monetary system. These approaches were subsequently broadly endorsed by the Interim Committee, which sketched out a comprehensive framework for strengthening the architecture of the monetary system. The Board discussion in April, as well as the Interim Committee communiqué, centered on five aspects of a strengthened international monetary system:

• reinforcing international and domestic financial
• strengthening IMF surveillance;
• promoting greater availability and transparency of
   information regarding member countries’ economic
   data and policies;
• underscoring the central role of the IMF in crisis
   management; and
• establishing effective procedures to involve the private
   sector in forestalling or resolving financial crises.
Since the Mexican financial crisis of 1994/95, the IMF has taken a number of steps to enhance the functioning of the international monetary system. The heightened challenges posed by the ongoing globalization of financial markets as exemplified by the Asian financial crisis highlighted the need for further efforts in this direction. In its continuing discussions of additional initiatives to strengthen the architecture of the international monetary system, the Executive Board in 1997/98 identified several imperatives (see box).

Analysis of the lessons learned from the crisis and the IMF’s experience with member countries have led the IMF to suggest a number of approaches for strengthening the international monetary system that would improve the ability of countries to realize the full potential of globalization while containing its risks. More broadly, the IMF’s experience with its member countries has shown that although macroeconomic stability, establishment of the basic institutional framework for a market economy, openness to the world economy, and market-friendly structural policies are essential for strong growth, deeper and broader-based reforms are often necessary to achieve high-quality growth that is sustainable and more equitably shared. These second generation reforms address a number of problems highlighted by recent crises. They include measures to address corruption and to encourage improved private and public sector governance, greater transparency of government budgets, and more efficient and robust financial sectors.

Governance and Transparency

The Executive Board has adopted guidelines to clarify the IMF’s role in governance issues. These call for a more comprehensive treatment of such issues, in the context of both Article IV consultations and IMF-supported programs; evenhanded treatment of member countries; and enhanced collaboration with other institutions, including, notably, the World Bank. In order to enhance the accountability and credibility of members’ fiscal policies, the Interim Committee of the Board of Governors, at its April 1998 meeting, adopted a Code of Good Practices on Fiscal Transparency: Declaration on Principles (see box below).

Code of Good Practices on Fiscal
Transparency: Declaration on Principles
The Code’s main provisions are as follows:
Clarity of Roles and Responsibilities
   • The government sector should be clearly distinguished from the rest of the economy,
      and policy and management roles within government should be well defined.
   • There should be a clear legal and administrative framework for fiscal management.
Public Availability of Information
   • The public should be provided with full information on the past, current, and projected
      fiscal activity of government.
   • A public commitment should be made to timely publication of fiscal information.
Open Budget Preparation, Execution, and Reporting
   • Budget documentation should specify fiscal policy objectives, the macroeconomic
      framework, the policy basis for the budget, and identifiable major fiscal risks.
   • Budget estimates should be classified and presented in a way that facilitates policy
      analysis and promotes accountability.
   • Procedures for the execution and monitoring of approved expenditures should be clearly specified.
   • Fiscal reporting should be timely, comprehensive, reliable, and identify deviations from the budget.
Independent Assurances of Integrity
   • The integrity of fiscal information should be subject to public and independent scrutiny.

To guide members in disseminating data to the public, the Executive Board endorsed a two-tier approach: the Special Data Dissemination Standard, established in March 1996 for countries that have or might seek access to international financial markets, and a less comprehensive General Data Dissemination System, approved in December 1997, for all member countries.

To enhance the transparency of its surveillance, the IMF in May 1997 initiated Press Information Notices (subsequently renamed Public Information Notices) following the conclusion of Article IV consultations. PINs summarize the Executive Board’s assessment of member countries’ economic policies and prospects. Of the 134 Article IV consultations in 1997/98, 77 were summarized in PINs. PINs appear on the IMF’s web site (www.imf.org) and are published three times a year as IMF Economic Reviews.

Expanding IMF Resources

While strengthened IMF surveillance, encompassing greater transparency, is intended to forestall major disruptions in the world economy or lessen their severity, it is unlikely that it will ever be possible to prevent all crises. This underscores the importance of the adequacy of the IMF’s resources to help countries deal with crises when they occur. In 1997/98, the Executive Board agreed that IMF quotas should be increased by 45 percent, and this increase will take effect after members having not less than 85 percent of total quotas as of December 23, 1997, have consented to their quota increases. The Executive Board also agreed to renew the General Arrangements to Borrow for another five years from December 26, 1998, to December 25, 2003. Also awaiting the formal approval of the membership are the New Arrangements to Borrow, which were approved by the Executive Board in early 1997. An agreement was also reached in the Board to amend the Articles of Agreement to allow for a special one-time allocation of SDRs to equalize members’ ratios of cumulative allocations to their Ninth Review quotas at approximately 29.32 percent. This amendment also has yet to be formally approved by member countries.

Capital Account Convertibility

At the Annual Meetings in Hong Kong SAR in September 1997, the Interim Committee issued a Statement on the Liberalization of Capital Movements Under an Amendment of the IMF’s Articles of Agreement. The statement invited the Executive Board to complete its work on a proposed amendment to make the liberalization of capital movements one of the purposes of the IMF and to extend, as needed, the IMF’s jurisdiction in this area. In 1997/98, the Board considered various aspects of such an amendment and, to help inform its work, sponsored a high-level seminar in March 1998 to elicit views from a wide range of private and official observers outside the IMF. Following the seminar, the Board has continued its work on this matter and will report on progress to the Interim Committee at its October 1998 meeting.

Assistance to Low-Income Countries

The Executive Board undertook an extensive review drawing on both internal and external assessments of the IMF’s concessional lending facility for low-income countries, the ESAF, and continued its work aimed at ensuring the uninterrupted availability of resources for the ESAF. The Board also reviewed the lessons to date of experience with the ESAF. In addition, the IMF, together with the World Bank and other creditors, made important headway in implementing the initiative to reduce the external debt burden of a number of heavily indebted poor countries, to which about $8 billion had been pledged by bilateral, commercial, and multilateral creditors.

Capital Liberalization Under an Amendment of the IMF’s Articles
Private capital flows have become much more important to the international monetary system, and an increasingly open and liberal system has proved to be highly beneficial to the world economy. By facilitating the flow of savings to their most productive uses, capital movements increase investment, growth, and prosperity. Provided it is introduced in an orderly manner and backed both by adequate national policies and a solid multilateral system for surveillance and financial support, the liberalization of capital flows is an essential element of an efficient international monetary system in this age of globalization. The IMF’s central role in the international monetary system and its near-universal membership make it uniquely placed to help this process.

During 1997/98, the Board met to discuss various aspects of a possible amendment to the IMF’s Articles with respect to liberalization of capital movements and the IMF’s role. At the Annual Meetings in Hong Kong SAR in September 1997, the Interim Committee issued a Statement on the Liberalization of Capital Movements Under an Amendment of the IMF’s Articles of Agreement. The statement invited the Executive Board to complete its work on a proposed amendment of the IMF’s Articles to make the liberalization of capital movements one of the purposes of the IMF and extend, as needed, the IMF’s jurisdiction through the establishment of carefully defined and uniformly applied obligations regarding the liberalization of such movements.

The IMF hosted a seminar in March 1998 to elicit views from a wide range of private and official observers outside the IMF on bringing the liberalization of capital movements within its mandate. Participants included senior government officials, private sector representatives, academicians, and representatives from international organizations. IMF senior staff, management, and members of the Executive Board also participated. Seminar participants agreed that the Asian crisis confirmed the importance of orderly and properly sequenced liberalization of capital movements, the need for appropriate macroeconomic and exchange rate policies, and the critical role of a sound financial sector. In the current globalized environment, the trend toward greater liberalization was here to stay, and the real issues were how, when, and under what circumstances capital flows should be liberalized. A number of speakers noted that weakness in the financial sector lay at the heart of the crises in Indonesia, Korea, and Thailand. The main problems were the limited capacity of financial institutions to assess and manage risks, inadequate prudential supervision, and ad hoc liberalization of capital movements. With respect to the latter, it was noted that it was not liberalization per se, but its form and sequence that rendered countries vulnerable to changes in market sentiment.

A number of speakers felt that the Asian crisis demonstrated that liberalization should be approached cautiously in concert with progress in other areas to realize fully its benefits. Participants acknowledged that the IMF had a central role to play in promoting the orderly liberalization of capital movements, but views differed as to whether IMF “advocacy” of freer capital markets or “jurisdiction” over its members’ capital account regulations was the more appropriate means for the IMF to achieve this goal.