## CHAPTER I ## Source details **Canonical URL:** [CHAPTER I](https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/ar/98/pdf/_file02pdf.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/ar/98/pdf/_file02pdf.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/ar/98/pdf/_file02pdf.pdf.json) --- ### Global capital flows and emerging markets - Sharp declines in private capital flows to emerging market economies in Asia required substantial adjustments in these countries’ external positions. - For the Asian developing countries, taken together, the current account deficit narrowed by almost $30 billion in 1997. - By early 1998, the countries most affected by the crisis—Indonesia, Korea, and Thailand—were each running current account surpluses. - In 1997 as a whole, a widening of current account deficits among a number of Latin American countries, reflecting the increase in foreign direct investment in the region, was the main counterpart to the narrowing of deficits in the Asian emerging markets. - In the first quarter of 1998, net capital inflows to emerging market countries remained close to their already reduced levels of late 1997. - The redirection of financial flows toward the mature markets following the onset of the crisis helped support declines in medium- and long-term interest rates in industrial countries in late 1997 and early 1998. ### Commodity prices, inflation, and current accounts - Consumer price inflation declined further in each of the main country groups in 1997. - Oil prices and non-oil commodity prices weakened in early 1998: - By April 1998, in SDR terms, oil prices were about 31 percent lower than a year earlier. - Non-oil commodity prices had fallen by 20 percent over the same period. - Declines in commodity prices reflected reduced demand in countries embroiled in the Asian crisis and possible reductions in foreign currency prices of commodity exports following sharp currency depreciations. - In late 1997 and early 1998, a number of advanced economies—most notably the United States—and the oil-exporting countries began to show signs of deteriorating current account balances. ### Financial markets and interest rates - Easing of financial conditions in North America and western Europe contributed to further gains in equity markets, with many indices reaching new peaks. - Medium- and long-term interest rates in several industrial countries fell to 50-year lows in late 1997 and early 1998. - Six-month LIBOR rates (in percent) reported: - On U.S. dollar deposits: 5.1, 6.1, 5.6, 5.9 (for 1994, 1995, 1996, 1997 respectively). - On Japanese yen deposits: 2.4, 1.3, 0.7, 0.7. - On deutsche mark deposits: 5.3, 4.6, 3.3, 3.4. ### Exchange rates and regional developments - The yen experienced strong selling pressures for most of the period; after falling to ¥127 per dollar at the end of April 1997, it rebounded to ¥110 in May/early June, then weakened again to ¥132 per dollar by the end of April 1998. - The deutsche mark depreciated further against the dollar during 1997 and in early 1998, but the depreciation in nominal effective terms was moderate. - The pound sterling rose steeply in 1997 and in early 1998, owing mainly to short-term cyclical factors. - Regional currency depreciations reduced competitiveness in Hong Kong SAR; interest rates rose sporadically there in the face of intermittent pressures on the currency. - The Australian dollar depreciated substantially late in the year, with official interest rates raised in late 1997 and in January 1998. ### Advanced economies: cyclical divergences and growth - Cyclical divergences remained sizable among advanced economies in 1997. - United States: - GDP grew at 3#/4percent in 1997. - Inflation in terms of the GDP deflator was the lowest in 32 years. - Unemployment fell to its lowest level in 24 years. - The federal budget was virtually in balance for the first time since the early 1970s. - United Kingdom: - Output grew by 3#/4percent in 1997. - Unemployment fell by year-end to 5 percent—a 17-year low. - Japan: - The economy faltered after the first quarter of 1997 and slipped into recession in the fourth quarter. - Output contracted in the first quarter of 1998 by 5.3 percent at an annual rate. - For the year as a whole, GDP grew by #/4of 1 percent. - Japanese authorities announced a large fiscal stimulus package in April 1998 and later a Comprehensive Plan for Financial Revitalization in July 1998, including a “bridge bank” facility and measures to strengthen bank supervision and increase transparency. - Continental Europe: - Germany, France, and Italy saw moderately strengthened growth in 1997 after two weak years; inflation was less than 2 percent in each in 1997. - Other continental European economies (Denmark, Finland, Ireland, Luxembourg, the Netherlands, Norway, Portugal, Spain) continued strong growth in 1997; Austria, Belgium, and Sweden showed more convincing expansions. - Switzerland’s subdued growth continued, with activity picking up in the first quarter of 1998. ### European Economic and Monetary Union (EMU) - In March 1998, the European Commission determined that 11 of the 15 EU member states had qualified to participate in European Economic and Monetary Union (EMU) in 1999, based on meeting the Maastricht Treaty convergence criteria for 1997 on inflation, public finances, interest rates, and exchange rates. - Denmark, Sweden, and the United Kingdom indicated they did not wish to participate immediately in EMU; the Greek government aimed to join EMU in 2001. In March 1998, the drachma joined the... ### Selected key statistics (from Table 1: Overview of the World Economy) - World output: 3.9, 3.6, 4.1, 4.1 (1994, 1995, 1996, 1997 respectively). - Advanced economies: 3.1, 2.5, 2.7, 3.0. - Major industrial countries: 2.8, 2.0, 2.5, 2.8. - United States: 3.5, 2.0, 2.8, 3.8. - Japan: 0.6, 1.5, 3.9, 0.9. - United Kingdom: 4.3, 2.7, 2.2, 3.3. - Developing countries: 6.8, 6.0, 6.6, 5.8. - Asia: 9.6, 9.0, 8.3, 6.7. - ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand): 7.7, 8.1, 7.1, 3.9. - World trade volume (goods and services): 9.3, 9.5, 6.6, 9.4. - Oil prices (simple average, U.K. Brent, Dubai, WTI): In SDRs: –7.8, 1.9, 24.3, –0.9; In U.S. dollars: –5.5, 8.0, 18.9, –6.0. - Nonfuel commodity prices (average, world commodity export weights): In SDRs: 10.8, 2.1, 3.1, 1.6; In U.S. dollars: 13.6, 8.2, –1.3, –3.7. - Consumer prices (advanced economies): 2.6, 2.5, 2.4, 2.1. - Consumer prices (developing countries): 50.7, 21.7, 13.7, 8.5. - Countries in transition (consumer prices): 268.4, 124.1, 41.4, 27.8. ### Selected key statistics (from Table 2: Net Capital Flows) - Total net private capital flows: 15.2 (1984–89), 148.1 (1990–96), 160.5 (1994), 192.0 (1995), 240.8 (1996), 173.7 (1997). - Total net direct investment: 12.9, 63.1, 84.3, 96.0, 114.9, 138.2. - Developing countries, net private capital flows: 18.2, 131.2, 136.6, 156.1, 207.9, 154.7. - Asia, net private capital flows: 13.0, 55.9, 63.1, 91.8, 102.2, 38.5. - Asia, net direct investment: 4.5, 32.2, 43.4, 49.7, 58.5, 55.4. - Western Hemisphere, net private capital flows: –0.2, 45.7, 47.4, 35.7, 80.5, 91.1. - Countries in transition, net private capital flows: –1.0, 12.8, 18.4, 29.8, 21.3, 34.5. - Newly industrialized economies, net private capital flows: –2.0, 4.1, 5.5, 6.1, 11.7, –15.4. ### Developing Countries: growth, spillovers, and regional outcomes - Developing countries as a group: economic growth slowed to 5#/4percent in 1997 from about 6!/2percent in 1996. - Key aggravating factors: contagion from the Asian crisis, generally higher risk premiums on foreign credits, loss of competitiveness, lower commodity prices, domestic and external imbalances. - Regional highlights: - Asia: - China: financial markets relatively immune to contagion; trade position remained strong; current account continued in surplus; authorities committed to not devaluing the renminbi; inflation remained low following the sharp drop in 1997. - India: output growth declined to about 6 percent in 1997 from about 7!/2percent in 1996; rupee weakened against the dollar in late 1997 but little changed on a real multilateral basis. - Pakistan: government adopted a program to strengthen macroeconomic policies and implemented structural reforms after late 1996/early 1997 imbalances. - Latin America: - Brazil: consumer price inflation declined to 4!/4percent in 1997; output growth at 3 percent similar to previous year; monetary and fiscal policies tightened in October and November 1997 to restore confidence and halt reserve drains. - Argentina: output grew by a robust 8!/2 percent in 1997; prices remained broadly stable; financial market pressures emerged in October 1997. - Mexico: experienced marked increase in exchange market and interest rate volatility; temporary increase in interest rates stabilized the exchange rate; peso fell against the dollar in February 1998. - Chile: peso pressure in December stabilized by late January after intervention and sizable interest rate increase. - Middle East and Europe (developing): limited direct spillovers from Asia; temporary equity declines and wider interest spreads; Iran: real GDP growth slowed to 3!/4percent in 1997 from 4#/4percent in 1996. - Africa: - Regional growth in 1997: 3!/4percent. - Factors: poor weather, declines in commodity prices, some armed conflicts. - South Africa: growth slowed to 1#/4percent in 1997. - Nigeria: weak domestic demand and low foreign investor confidence. - Algeria: slowed significantly due to drought and delays in industrial recovery. - Kenya: growth weakened partly due to financial market pressures related to political uncertainties. - Inflation: remained under control in most of the region. ### Transition Economies: stabilization, contagion, and reform - Aggregate outcomes: transition countries as a group grew by 1#/4percent in 1997; inflation reduced to about 27 percent. - Countries experiencing spillovers or pressures: - Russia: ruble attacks in late October/November 1997 and again late January 1998; authorities defended exchange rate by sharply raising interest rates; steep stock market declines; pressures occurred despite external current account close to balance and amid weak fiscal position and falling oil prices. - Ukraine: inadequate fiscal adjustment increased reliance on official short-term foreign borrowing; late-1997 contagion forced a sharp tightening of monetary conditions. - Estonia: rising domestic financial market pressures associated with a burgeoning current account deficit aggravated by Asian contagion; interest rates rose substantially in October-November 1997; equity prices fell sharply. - Other transition cases: - Czech Republic: currency crisis in May 1997 partly triggered by Thailand events; tightened fiscal and monetary policies, narrowing current account deficit at the cost of slower growth. - Hungary: little exchange market pressure owing to improved fiscal, growth, and trade performance since 1995. - Poland: output grew by about 7 percent in 1997, continuing a nearly six-year expansion. - Albania and Bulgaria: financial crises in 1996–97 led to output declines; following significant policy improvements, macroeconomic imbalances narrowed and growth resumed in late 1997/early 1998; Bulgaria recorded a dramatic decline in inflation in 1997 with a currency board arrangement central to the IMF-supported program. - Policy concerns: - Continued sizable deficits in several transition countries, including Russia and Ukraine. - Financing deficits through foreign currency and short-term borrowing increased vulnerability and threatened banking sector soundness. - Severe revenue collection problems hindered governments’ ability to perform essential functions; need for tax policy reform, improved tax administration, and stronger political will to collect taxes. - Recommendation to improve cost-effectiveness of social security and welfare systems to reduce overall government spending. ### Advanced Economies: impacts, policy responses, and region-by-region views - Japan: - Recovery stalled in first half of 1997 due to an overly tight fiscal policy and continuing financial system fragilities. - Directors recommended boosting confidence and sustainable growth through a combination of macroeconomic, financial sector, and structural policies. - Near-term policy: more expansionary fiscal stance recommended while maintaining medium-term consolidation objectives. - Views on fiscal stimulus: some Directors favored permanent tax cuts to boost private consumption; others cautioned tax cuts might be saved rather than spent. Public works spending viewed as temporary and of limited past effectiveness. - Financial measures: welcome for public funds to protect depositors and recapitalize viable institutions; caution against indiscriminate support and recommendation that public funds be accompanied by measures to facilitate write-off of bad loans and limit moral hazard. - United States: - Likely to suffer relatively little from Asian crisis due to strong cyclical position and bond market developments reflecting a “flight to quality”. - Current monetary stance judged appropriate given moderating effects of the Asian crisis, U.S. dollar appreciation, and commodity price declines; authorities should monitor tightening labor market conditions. - Europe: - Spillover risks to advanced European economies judged relatively small. - United Kingdom: prior monetary tightening and fiscal consolidation expected to keep demand near capacity and inflation near target; vigilance warranted if inflation prospects worsened. - Germany, France, Italy: output recovered since early 1997 and overall Asian impact expected to be small; caution that export weakness could slow recovery if domestic demand does not pick up. - Continental Europe: with monetary union scheduled to begin in nine months, emphasis on labor and product market reforms, continued fiscal consolidation, and attention to monetary policy during transition. ### World Economic Outlook, Board discussions, and international capital markets - IMF Executive Board held three World Economic Outlook discussions in August 1997, December 1997 (Interim Assessment), and March 1998; central focus was the Asian financial crisis. - Key messages from Directors (August 1997, March 1998): - No room for complacency about risks and fragilities that could affect regional and global conditions. - Importance of disciplined macroeconomic policies and timely structural reforms to eliminate unsustainable imbalances. - Need for broader institutional reforms: public administration efficiency, human capital development, financial sector management, transparent regulatory and legal systems, and improved governance to sustain private sector and investor confidence. - Uncertainty remained regarding crisis resolution; resolute reform implementation in crisis countries essential. - Declines in oil and commodity prices could lengthen adjustment and pose challenges for commodity and oil-exporting countries. - Reevaluation of risks by international lenders could limit financial flows to developing and transition economies. - Concern that some emerging markets relied too heavily on foreign borrowing and short-term instruments to finance public deficits. - International capital markets: - July 1997 review: Directors discussed mature and emerging capital markets, banking systems, implications of European Economic and Monetary Union, strategies for dealing with speculative attacks, and management of sovereign external liabilities. - March 1998: Board examined the role of hedge funds and institutional investors in the context of the Asian crisis and integrated capital markets. - Observed narrowing of interest rate differentials among mature economies attributed to fiscal consolidation, lower inflation, and increased competition in international banking markets; convergence seen as signaling market expectations of a broad EMU beginning on January 1. ### Policy recommendations and priorities emphasized by Directors - For crisis countries: - Resolute implementation of macroeconomic stabilization and structural reforms. - Strengthen financial sector infrastructure: prudential regulation, internationally accepted accounting standards, and preestablished exit rules for exchange rate regimes. - Ensure fiscal consolidation to reduce vulnerability and restore investor confidence. - For advanced economies: - Japan: combine fiscal stimulus with serious regulatory and financial sector reforms; accompany public support with mechanisms to write off bad loans and limit moral hazard. - United States and Europe: monitor inflation and labor market signals; maintain vigilance given external developments. - For developing and transition countries more broadly: - Contain external imbalances and avoid overheating. - Enhance quality and timeliness of economic and financial information. - Create favorable environment for foreign direct investment through further opening up of economies. - For Africa: continue macroeconomic adjustment and structural reforms and ensure appropriate flows of foreign assistance. ### Equity markets, banking, hedge funds, and regulatory considerations - Equity markets in mature economies: - Many Directors were concerned about the potential for corrections in some equity markets and the possible negative impact of such corrections, especially in emerging equity markets. - Directors urged careful monitoring of stock markets in the United States and other economies. - Banking in mature markets: - Banking systems in some mature markets had been highly profitable during the preceding 12 months, while others continued to be affected by high levels of nonperforming loans. - As distinctions between banks and other financial institutions blurred, a growing number of countries had moved toward consolidating supervision over a broad range of financial institutions into one agency. - Market-based solutions were seen as desirable for addressing banking sector problems. - Concerns about fiscal costs and moral hazard associated with public interventions to address troubled financial institutions. - Hedge funds: - Industry capital estimates (excluding “funds of funds”) suggested hedge fund capital was in the neighborhood of $100 billion as of the third quarter of 1997. - Of that, some $25 billion was in the hands of so-called macro funds. - Macro funds typically leverage their capital through borrowing by a factor of 4 to 7. - Remainder managed by relative value funds, which tend to be more highly leveraged than macro funds. - Capital of other institutional investors (investment and commercial banks) exceeded $20 trillion in the mature markets alone. - Directors differed on hedge funds’ impact on market dynamics; some saw potential for large positions and herding, others saw limited evidence of destabilizing behavior. - On regulation: diverse views—some Directors saw little case for new regulations specific to hedge funds; others urged exploring options to increase transparency across hedge funds and other institutional investors. ### Speculative attacks, exchange rate regimes, and sovereign debt management - Speculative attacks and exchange rate regimes: - Growing integration increased the likelihood that perceived macroeconomic uncertainties and structural weaknesses would generate large-scale speculative pressures on rigidly managed exchange rate arrangements more than on flexible regimes. - First line of defense: sound macroeconomic policies. - Graduated defense when fundamentals are broadly correct: first sterilized foreign exchange intervention; then, if necessary, unsterilized intervention allowing short-term domestic interest rates to rise. - Limited, short-term role for capital controls in crisis situations to buy time to undertake corrective policies; not a substitute for necessary reforms. - Importance of moving to more flexible exchange rate systems in face of sustained market pressures. - Managing sovereign external liabilities: - Foreign currency borrowing should be guided by strategic debt-management considerations—namely, the ability to generate corresponding foreign currency revenues—and not be driven by short-term fiscal savings. - Cost considerations should be based on the hedged (risk-adjusted) cost for a country. - Debt-management strategy should incorporate clear guidelines on currency composition and maturity structure and take into account foreign borrowing by the private sector, especially commercial banks. - Risks and constraints from a large stock of short-term foreign currency debt noted; the unfolding Asian turmoil cited as an example. - Potential merits of a separate debt-management agency with expertise in risk-management techniques highlighted. - Need for coordination and consistency between such an agency and monetary and fiscal authorities. ### EMU discussions and policy messages (1997–1998) - Completion of EMU viewed as a milestone in European economic integration and of major importance for the international monetary system. - Directors underlined desirability of completing the project in a timely way and noted much had been accomplished preparing EU economies for EMU and establishing the policy framework for when monetary union commenced. - Most EU countries had achieved a high degree of convergence required by the Maastricht Treaty, notably regarding inflation, but further progress was needed in the fiscal area in 1997. - Additional fiscal measures deemed necessary in 1998 to reduce deficits further in line with medium-term requirements reflected in the Stability and Growth Pact. - Continuing high structural unemployment in Europe was a concern; urgent action needed to reduce labor market rigidities in most EU countries. - Inadequate labor market flexibility would impair ability to adjust to asymmetric shocks under a common monetary and exchange rate policy. - Risk that failure to address labor market rigidities would result in persistently high unemployment, eroding public support for low-inflation macroeconomic policies. - Importance of factor and product market liberalization to ensure sustainable growth and job creation in the EU. - In establishing macroeconomic policy framework for the monetary union, balance needed between policymakers’ flexibility and rules to underpin credibility. - Directors thought the Stability and Growth Pact struck a reasonable balance. - Surveillance by the EU’s Council oriented to early warning of excessive deficits, together with threat of financial penalties, should provide a bulwark against fiscal indiscipline. - Directors generally agreed the euro would, over time, constitute an attractive reserve currency that might rival the dollar; roles of euro and dollar would depend on developments in European financial markets, regulatory environment, instruments available, and fundamental economic developments. - By August 1997, Directors remarked on impressive economic convergence in Europe—strengthened public finances, lower inflation and interest rates, relatively stable exchange rates. - Some Directors felt advances and commitment reduced risks and uncertainties in the run-up to EMU. - Small excesses of actual deficits over the reference value should not be viewed as an impediment to EMU proceeding on schedule, given reductions in cyclically adjusted deficits and the Stability and Growth Pact framework. - A few Directors argued for strict application of the Maastricht fiscal deficit criterion to protect credibility. - Challenges for successful monetary union during transition: - Improving Europe’s labor market performance critical. - Comprehensive labor market reforms would boost medium-term growth, improve fiscal performance, help adjust to adverse disturbances under monetary union, and increase public support. - Independence, mandate, and capacity of the European System of Central Banks to achieve price stability should be safeguarded. - Introduction of the euro expected to accompany significant restructuring of financial markets and possible instability in money demand relationships. - ECB likely to use a wide range of indicators, especially in early stages of EMU; transparency of monetary policy important for credibility. - Despite fiscal consolidation progress, budgetary positions in many EU members might worsen medium to long term due to demographic developments; these problems must be addressed irrespective of EMU. - Interim Committee in April 1998 requested the Executive Board to examine further the implications of EMU for IMF operations and for the conduct of IMF surveillance and to report in time for the Committee’s next meeting in October 1998. _Annual Report 1998 — CHAPTER I_ ### CHAPTER I ### CHAPTER I ### Global capital flows and emerging markets - Sharp declines in private capital flows to emerging market economies in Asia required substantial adjustments in these countries’ external positions. - For the Asian developing countries, taken together, the current account deficit narrowed by almost $30 billion in 1997. - By early 1998, the countries most affected by the crisis—Indonesia, Korea, and Thailand—were each running current account surpluses. - In 1997 as a whole, a widening of current account deficits among a number of Latin American countries, reflecting the increase in foreign direct investment in the region, was the main counterpart to the narrowing of deficits in the Asian emerging markets. - In the first quarter of 1998, net capital inflows to emerging market countries remained close to their already reduced levels of late 1997. - The redirection of financial flows toward the mature markets following the onset of the crisis helped support declines in medium- and long-term interest rates in industrial countries in late 1997 and early 1998. ### Commodity prices, inflation, and current accounts - Consumer price inflation declined further in each of the main country groups in 1997. - Oil prices and non-oil commodity prices weakened in early 1998: - By April 1998, in SDR terms, oil prices were about 31 percent lower than a year earlier. - Non-oil commodity prices had fallen by 20 percent over the same period. - Declines in commodity prices reflected reduced demand in countries embroiled in the Asian crisis and possible reductions in foreign currency prices of commodity exports following sharp currency depreciations. - In late 1997 and early 1998, a number of advanced economies—most notably the United States—and the oil-exporting countries began to show signs of deteriorating current account balances. ### Financial markets and interest rates - Easing of financial conditions in North America and western Europe contributed to further gains in equity markets, with many indices reaching new peaks. - Medium- and long-term interest rates in several industrial countries fell to 50-year lows in late 1997 and early 1998. - Six-month LIBOR rates (in percent) reported: - On U.S. dollar deposits: 5.1, 6.1, 5.6, 5.9 (for 1994, 1995, 1996, 1997 respectively as shown in Table 1). - On Japanese yen deposits: 2.4, 1.3, 0.7, 0.7. - On deutsche mark deposits: 5.3, 4.6, 3.3, 3.4. ### Exchange rates and regional developments - The yen experienced strong selling pressures for most of the period; after falling to ¥127 per dollar at the end of April 1997, it rebounded to ¥110 in May/early June, then weakened again to ¥132 per dollar by the end of April 1998. - The deutsche mark depreciated further against the dollar during 1997 and in early 1998, but the depreciation in nominal effective terms was moderate. - The pound sterling rose steeply in 1997 and in early 1998, owing mainly to short-term cyclical factors. - Regional currency depreciations reduced competitiveness in Hong Kong SAR; interest rates rose sporadically there in the face of intermittent pressures on the currency. - The Australian dollar depreciated substantially late in the year, with official interest rates raised in late 1997 and in January 1998. ### Advanced economies: cyclical divergences and growth - Cyclical divergences remained sizable among advanced economies in 1997. - United States: - GDP grew at 3#/4percent in 1997. - Inflation in terms of the GDP deflator was the lowest in 32 years. - Unemployment fell to its lowest level in 24 years. - The federal budget was virtually in balance for the first time since the early 1970s. - United Kingdom: - Output grew by 3#/4percent in 1997. - Unemployment fell by year-end to 5 percent—a 17-year low. - Japan: - The economy faltered after the first quarter of 1997 and slipped into recession in the fourth quarter. - Output contracted in the first quarter of 1998 by 5.3 percent at an annual rate. - For the year as a whole, GDP grew by #/4of 1 percent. - Japanese authorities announced a large fiscal stimulus package in April 1998 and later a Comprehensive Plan for Financial Revitalization in July 1998, including a “bridge bank” facility and measures to strengthen bank supervision and increase transparency. - Continental Europe: - Germany, France, and Italy saw moderately strengthened growth in 1997 after two weak years; inflation was less than 2 percent in each in 1997. - Other continental European economies (Denmark, Finland, Ireland, Luxembourg, the Netherlands, Norway, Portugal, Spain) continued strong growth in 1997; Austria, Belgium, and Sweden showed more convincing expansions. - Switzerland’s subdued growth continued, with activity picking up in the first quarter of 1998. ### European Economic and Monetary Union (EMU) - In March 1998, the European Commission determined that 11 of the 15 EU member states had qualified to participate in European Economic and Monetary Union (EMU) in 1999, based on meeting the Maastricht Treaty convergence criteria for 1997 on inflation, public finances, interest rates, and exchange rates. - Denmark, Sweden, and the United Kingdom indicated they did not wish to participate immediately in EMU; the Greek government aimed to join EMU in ### Selected key statistics from Table 1 (Overview of the World Economy) - World output: 3.9, 3.6, 4.1, 4.1 (1994, 1995, 1996, 1997 respectively). - Advanced economies: 3.1, 2.5, 2.7, 3.0. - Major industrial countries: 2.8, 2.0, 2.5, 2.8. - United States: 3.5, 2.0, 2.8, 3.8. - Japan: 0.6, 1.5, 3.9, 0.9. - United Kingdom: 4.3, 2.7, 2.2, 3.3. - Developing countries: 6.8, 6.0, 6.6, 5.8. - Asia: 9.6, 9.0, 8.3, 6.7. - ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand): 7.7, 8.1, 7.1, 3.9. - World trade volume (goods and services): 9.3, 9.5, 6.6, 9.4. - Oil prices (simple average, U.K. Brent, Dubai, WTI): In SDRs: –7.8, 1.9, 24.3, –0.9; In U.S. dollars: –5.5, 8.0, 18.9, –6.0. - Nonfuel commodity prices (average, world commodity export weights): In SDRs: 10.8, 2.1, 3.1, 1.6; In U.S. dollars: 13.6, 8.2, –1.3, –3.7. - Consumer prices (advanced economies): 2.6, 2.5, 2.4, 2.1. - Consumer prices (developing countries): 50.7, 21.7, 13.7, 8.5. - Countries in transition (consumer prices): 268.4, 124.1, 41.4, 27.8. ### Selected key statistics from Table 2 (Net Capital Flows) - Total net private capital flows: 15.2 (1984–89), 148.1 (1990–96), 160.5 (1994), 192.0 (1995), 240.8 (1996), 173.7 (1997). - Total net direct investment: 12.9, 63.1, 84.3, 96.0, 114.9, 138.2 (same periods). - Developing countries, net private capital flows: 18.2, 131.2, 136.6, 156.1, 207.9, 154.7. - Asia, net private capital flows: 13.0, 55.9, 63.1, 91.8, 102.2, 38.5. - Asia, net direct investment: 4.5, 32.2, 43.4, 49.7, 58.5, 55.4. - Western Hemisphere, net private capital flows: –0.2, 45.7, 47.4, 35.7, 80.5, 91.1. - Countries in transition, net private capital flows: –1.0, 12.8, 18.4, 29.8, 21.3, 34.5. - Newly industrialized economies, net private capital flows: –2.0, 4.1, 5.5, 6.1, 11.7, –15.4. *Source: ANNUAL REPORT 1998 — CHAPTER I* ### 2001. In March 1998, the drachma joined the ### 2001. In March 1998, the drachma joined the ### Developing Countries: growth, spillovers, and regional outcomes - Developing countries as a group: economic growth slowed to 5#/4percent in 1997 from about 6!/2percent in 1996. - Key aggravating factors: contagion from the Asian crisis, generally higher risk premiums on foreign credits, loss of competitiveness, lower commodity prices, domestic and external imbalances. - Regional highlights: - Asia: - China: financial markets relatively immune to contagion; trade position remained strong; current account continued in surplus; authorities committed to not devaluing the renminbi; inflation remained low following the sharp drop in 1997. - India: output growth declined to about 6 percent in 1997 from about 7!/2percent in 1996; rupee weakened against the dollar in late 1997 but little changed on a real multilateral basis. - Pakistan: government adopted a program to strengthen macroeconomic policies and implemented structural reforms after late 1996/early 1997 imbalances. - Latin America: - Brazil: consumer price inflation declined to 4!/4percent in 1997; output growth at 3 percent similar to previous year; monetary and fiscal policies tightened in October and November 1997 to restore confidence and halt reserve drains. - Argentina: output grew by a robust 8!/2 percent in 1997; prices remained broadly stable; financial market pressures emerged in October 1997. - Mexico: experienced marked increase in exchange market and interest rate volatility; temporary increase in interest rates stabilized the exchange rate; peso fell against the dollar in February 1998. - Chile: peso pressure in December stabilized by late January after intervention and sizable interest rate increase. - Middle East and Europe (developing): limited direct spillovers from Asia; temporary equity declines and wider interest spreads; Iran: real GDP growth slowed to 3!/4percent in 1997 from 4#/4percent in 1996. - Africa: - Regional growth in 1997: 3!/4percent. - Factors: poor weather, declines in commodity prices, some armed conflicts. - South Africa: growth slowed to 1#/4percent in 1997. - Nigeria: weak domestic demand and low foreign investor confidence. - Algeria: slowed significantly due to drought and delays in industrial recovery. - Kenya: growth weakened partly due to financial market pressures related to political uncertainties. - Inflation: remained under control in most of the region. ### Transition Economies: stabilization, contagion, and reform - Aggregate outcomes: transition countries as a group grew by 1#/4percent in 1997; inflation reduced to about 27 percent. - Countries experiencing spillovers or pressures: - Russia: ruble attacks in late October/November 1997 and again late January 1998; authorities defended exchange rate by sharply raising interest rates; steep stock market declines; pressures occurred despite external current account close to balance and amid weak fiscal position and falling oil prices. - Ukraine: inadequate fiscal adjustment increased reliance on official short-term foreign borrowing; late-1997 contagion forced a sharp tightening of monetary conditions. - Estonia: rising domestic financial market pressures associated with a burgeoning current account deficit aggravated by Asian contagion; interest rates rose substantially in October-November 1997; equity prices fell sharply. - Other transition cases: - Czech Republic: currency crisis in May 1997 partly triggered by Thailand events; tightened fiscal and monetary policies, narrowing current account deficit at the cost of slower growth. - Hungary: little exchange market pressure owing to improved fiscal, growth, and trade performance since 1995. - Poland: output grew by about 7 percent in 1997, continuing a nearly six-year expansion. - Albania and Bulgaria: financial crises in 1996–97 led to output declines; following significant policy improvements, macroeconomic imbalances narrowed and growth resumed in late 1997/early 1998; Bulgaria recorded a dramatic decline in inflation in 1997 with a currency board arrangement central to the IMF-supported program. - Policy concerns: - Continued sizable deficits in several transition countries, including Russia and Ukraine. - Financing deficits through foreign currency and short-term borrowing increased vulnerability and threatened banking sector soundness. - Severe revenue collection problems hindered governments’ ability to perform essential functions; need for tax policy reform, improved tax administration, and stronger political will to collect taxes. - Recommendation to improve cost-effectiveness of social security and welfare systems to reduce overall government spending. ### Advanced Economies: impacts, policy responses, and region-by-region views - Japan: - Recovery stalled in first half of 1997 due to an overly tight fiscal policy and continuing financial system fragilities. - Directors recommended boosting confidence and sustainable growth through a combination of macroeconomic, financial sector, and structural policies. - Near-term policy: more expansionary fiscal stance recommended while maintaining medium-term consolidation objectives. - Views on fiscal stimulus: some Directors favored permanent tax cuts to boost private consumption; others cautioned tax cuts might be saved rather than spent. Public works spending viewed as temporary and of limited past effectiveness. - Financial measures: welcome for public funds to protect depositors and recapitalize viable institutions; caution against indiscriminate support and recommendation that public funds be accompanied by measures to facilitate write-off of bad loans and limit moral hazard. - United States: - Likely to suffer relatively little from Asian crisis due to strong cyclical position and bond market developments reflecting a “flight to quality”. - Current monetary stance judged appropriate given moderating effects of the Asian crisis, U.S. dollar appreciation, and commodity price declines; authorities should monitor tightening labor market conditions. - Europe: - Spillover risks to advanced European economies judged relatively small. - United Kingdom: prior monetary tightening and fiscal consolidation expected to keep demand near capacity and inflation near target; vigilance warranted if inflation prospects worsened. - Germany, France, Italy: output recovered since early 1997 and overall Asian impact expected to be small; caution that export weakness could slow recovery if domestic demand does not pick up. - Continental Europe: with monetary union scheduled to begin in nine months, emphasis on labor and product market reforms, continued fiscal consolidation, and attention to monetary policy during transition. ### World Economic Outlook, Board discussions, and international capital markets - IMF Executive Board held three World Economic Outlook discussions in August 1997, December 1997 (Interim Assessment), and March 1998; central focus was the Asian financial crisis. - Key messages from Directors (August 1997, March 1998): - No room for complacency about risks and fragilities that could affect regional and global conditions. - Importance of disciplined macroeconomic policies and timely structural reforms to eliminate unsustainable imbalances. - Need for broader institutional reforms: public administration efficiency, human capital development, financial sector management, transparent regulatory and legal systems, and improved governance to sustain private sector and investor confidence. - Uncertainty remained regarding crisis resolution; resolute reform implementation in crisis countries essential. - Declines in oil and commodity prices could lengthen adjustment and pose challenges for commodity and oil-exporting countries. - Reevaluation of risks by international lenders could limit financial flows to developing and transition economies. - Concern that some emerging markets relied too heavily on foreign borrowing and short-term instruments to finance public deficits. - International capital markets: - July 1997 review: Directors discussed mature and emerging capital markets, banking systems, implications of European Economic and Monetary Union, strategies for dealing with speculative attacks, and management of sovereign external liabilities. - March 1998: Board examined the role of hedge funds and institutional investors in the context of the Asian crisis and integrated capital markets. - Observed narrowing of interest rate differentials among mature economies attributed to fiscal consolidation, lower inflation, and increased competition in international banking markets; convergence seen as signaling market expectations of a broad EMU beginning on January 1. ### Policy recommendations and priorities emphasized by Directors - For crisis countries: - Resolute implementation of macroeconomic stabilization and structural reforms. - Strengthen financial sector infrastructure: prudential regulation, internationally accepted accounting standards, and preestablished exit rules for exchange rate regimes. - Ensure fiscal consolidation to reduce vulnerability and restore investor confidence. - For advanced economies: - Japan: combine fiscal stimulus with serious regulatory and financial sector reforms; accompany public support with mechanisms to write off bad loans and limit moral hazard. - United States and Europe: monitor inflation and labor market signals; maintain vigilance given external developments. - For developing and transition countries more broadly: - Contain external imbalances and avoid overheating. - Enhance quality and timeliness of economic and financial information. - Create favorable environment for foreign direct investment through further opening up of economies. - For Africa: continue macroeconomic adjustment and structural reforms and ensure appropriate flows of foreign assistance. *Source: excerpt from IMF Annual Report 1998, "The Global Economy" and World Economic Outlook discussions as presented in the supplied content.* ### 1999. As to a second major trend in the mature mar- ### 1999. As to a second major trend in the mature markets—the continued sharp advances in equity prices, particularly in the United States—many Directors felt that the relatively high valuations of stocks rested on investor expectations of continued strong growth in corporate earnings and relatively low inflation rates. ### Equity markets in mature economies - Many Directors were concerned about the potential for corrections in some equity markets and the possible negative impact of such corrections, especially in emerging equity markets. - Directors urged careful monitoring of stock markets in the United States and other economies. ### Banking in mature markets - Banking systems in some mature markets had been highly profitable during the preceding 12 months, while others continued to be affected by high levels of nonperforming loans. - Difficulties noted in ensuring effective financial supervision created by financial deregulation and globalization. - As distinctions between banks and other financial institutions blurred, a growing number of countries had moved toward consolidating supervision over a broad range of financial institutions into one agency. - Market-based solutions were seen as desirable for addressing banking sector problems. - Concerns that regulatory practices, local market power, rigid labor practices, and public ownership structures could delay required adjustments. - Cautions about fiscal costs and moral hazard associated with public interventions to address troubled financial institutions. ### Structural aspects of EMU - Creation of EMU viewed as an important international financial event likely to foster EMU-wide financial markets, benefit European banking systems, and lead to a more efficient European payments system. - Some consolidation and restructuring of banking systems seen as inevitable; diverse situations across European countries. - Importance of assessing performance of all types of financial institutions, including savings, post office, and cooperative banks. - Market-based solutions preferred; regulatory and structural impediments could delay adjustments. - Need to guard against fiscal costs and moral hazard from public interventions. ### Emerging markets — integration and private capital flows - Growing integration of many emerging markets into the global financial system evidenced by the record level of private capital flows to these countries in 1996. - Scale of flows reflected improvements in economic fundamentals, growing international diversification of institutional investor portfolios, and increased ability to search for higher yields. - Concern that interest rate spreads on emerging market bonds and syndicated loans might have been bid too low and that many investors might not be fully cognizant of the credit risks they faced. - Some Directors thought low emerging market spreads might reflect investor expectations that systemically important emerging markets would receive official assistance to avoid debt-service interruptions. - To avoid moral hazard, need to dispel the notion that the IMF would step in to bail out creditors. ### Speculative attacks and exchange rate regimes - Events in Thailand and neighboring foreign exchange markets demonstrated that growing integration increased the likelihood that perceived macroeconomic uncertainties and structural weaknesses would generate large-scale speculative pressures on rigidly managed exchange rate arrangements more than on flexible regimes. - Inflexible exchange rate systems could be sustained only if actively supported by strong macroeconomic policies and a sound financial system able to withstand sharp increases in interest rates to defend against speculative pressures. - First line of defense: sound macroeconomic policies. - Graduated defense when fundamentals are broadly correct: first sterilized foreign exchange intervention; then, if necessary, unsterilized intervention allowing short-term domestic interest rates to rise. - Limited, short-term role for capital controls in crisis situations to buy time to undertake corrective policies; not a substitute for necessary reforms. - Exchange restrictions discriminating between domestic and foreign residents considered inappropriate. - Choice of peg currency should consider currency composition of trade flows or of external borrowing. - Importance of moving to more flexible exchange rate systems in face of sustained market pressures. - Greater flexibility could reduce the need to build up foreign exchange reserves and mitigate sterilization costs associated with sizable capital inflows. ### Banking in emerging markets - Progress commended in improving health of banking systems in several countries, but significant problems remained in others. - Investor concerns about potential vulnerabilities in banking systems of some Asian emerging markets contributed to instability in foreign exchange markets. - Thai devaluation echoed concerns similar to those in the 1995 Mexican financial crisis. - Episodes underscored importance of sound risk management and prudential regulation in emerging market banking systems. ### Managing sovereign external liabilities - Importance of improving emerging market countries’ management of sovereign external liabilities (both gross and net). - Foreign currency borrowing seen as necessary for complementing domestic debt instruments, broadening the investor base, and establishing international benchmarks. - Foreign borrowing should be guided by strategic debt-management considerations—namely, the ability to generate corresponding foreign currency revenues—and not be driven by short-term fiscal savings. - Cost considerations should be based on the hedged (risk-adjusted) cost for a country. - Debt-management strategy should incorporate clear guidelines on currency composition and maturity structure and take into account foreign borrowing by the private sector, especially commercial banks. - Risks and constraints from a large stock of short-term foreign currency debt noted; the unfolding Asian turmoil cited as an example. - Greater policy transparency and accountability of debt managers seen as enhancing ability to manage exposures to external shocks. - Potential merits of a separate debt-management agency with expertise in risk-management techniques highlighted. - Need for coordination and consistency between such an agency and monetary and fiscal authorities. ### Hedge funds and financial market dynamics - Detailed information on hedge funds was limited; as private investment pools, hedge funds were not subject to most reporting and disclosure requirements applicable to banks and mutual funds. - Difficult to demarcate hedge fund industry boundaries from other institutional investors; great diversity of investment strategies. - Industry capital estimates (excluding “funds of funds”) suggested hedge fund capital was in the neighborhood of $100 billion as of the third quarter of 1997. - Of that, some $25 billion was in the hands of so-called macro funds. - Macro funds typically leverage their capital through borrowing by a factor of 4 to 7. - Remainder managed by relative value funds, which tend to be more highly leveraged than macro funds. - Capital of other institutional investors (investment and commercial banks) exceeded $20 trillion in the mature markets alone. - Directors differed on hedge funds’ impact on market dynamics: - Several emphasized that highly leveraged hedge funds could take large positions in smaller emerging markets and noted their relative freedom and flexibility. - Some argued hedge funds encouraged herding behavior; others saw limited evidence of that and noted potential contrarian or stabilizing roles. ### Hedge funds and the Asian crisis - Directors differed on hedge funds’ involvement in the Asian crisis: - Several saw no clear evidence that hedge funds took short positions against Asian currencies earlier than other investors or that their trades signaled others. - Noted that while hedge funds had large short positions on the Thai baht, that did not appear true for Asian currencies in general. - Access limitations by offshore counterparties to borrow domestic currency from onshore banks may have meant other investors with better access acted as market leaders. - The entire constellation of institutional investors, not merely hedge funds, had played a role in 1997 market fluctuations. - A few Directors felt hedge funds had played a more important role than indicated by the staff paper. - General agreement that events in Asia highlighted the need for sound and prudent macroeconomic policies that were transparent to markets to protect economies against sharp market volatility and speculation. - Specific recommendations: - Avoid offering one-way bets via inconsistent policies and indefensible currency pegs. - Maintain strong, well-regulated, and competitive financial systems. - Provide timely and comprehensive information to the public about government policy and private sector financial conditions. - Caution that disclosing market-sensitive information could on occasion trigger or worsen market volatility. ### More regulation? - Diverse views on additional regulatory and disclosure requirements for hedge funds: - Some Directors saw scant evidence of market failure specifically associated with hedge funds and considered the case for new regulations slim. - Others indicated that further options should be explored to render hedge fund operations more transparent and assure that hedge funds were not dominating or manipulating markets. - Warning that hedge funds are only part of a larger constellation of institutional investors; any useful reporting system would need to encompass commercial banks, investment banks, insurance companies, and pension funds. - Reporting systems more difficult to implement in over-the-counter environments (e.g., foreign exchange market) than on organized exchanges. - To be effective, reporting requirements would have to be applied by all countries; otherwise, market participants might book transactions offshore. ### EMU discussions and policy messages (1997–1998) - Completion of EMU viewed as a milestone in European economic integration and of major importance for the international monetary system. - Directors underlined desirability of completing the project in a timely way and noted much had been accomplished preparing EU economies for EMU and establishing the policy framework for when monetary union commenced. - Need for EU authorities to follow through on policy commitments and cooperate closely to secure foundations for a smooth transition to EMU. - Most EU countries had achieved a high degree of convergence required by the Maastricht Treaty, notably regarding inflation, but further progress was needed in the fiscal area in 1997. - Additional fiscal measures deemed necessary in 1998 to reduce deficits further in line with medium-term requirements reflected in the Stability and Growth Pact. - Continuing high structural unemployment in Europe was a concern; urgent action needed to reduce labor market rigidities in most EU countries. - Inadequate labor market flexibility would impair ability to adjust to asymmetric shocks under a common monetary and exchange rate policy. - Risk that failure to address labor market rigidities would result in persistently high unemployment, eroding public support for low-inflation macroeconomic policies. - Importance of factor and product market liberalization to ensure sustainable growth and job creation in the EU. - In establishing macroeconomic policy framework for the monetary union, balance needed between policymakers’ flexibility and rules to underpin credibility. - Directors thought the Stability and Growth Pact struck a reasonable balance. - Surveillance by the EU’s Council oriented to early warning of excessive deficits, together with threat of financial penalties, should provide a bulwark against fiscal indiscipline. - Directors generally agreed the euro would, over time, constitute an attractive reserve currency that might rival the dollar; roles of euro and dollar would depend on developments in European financial markets, regulatory environment, instruments available, and fundamental economic developments. - By August 1997, Directors remarked on impressive economic convergence in Europe—strengthened public finances, lower inflation and interest rates, relatively stable exchange rates. - Some Directors felt advances and commitment reduced risks and uncertainties in the run-up to EMU. - Small excesses of actual deficits over the reference value should not be viewed as an impediment to EMU proceeding on schedule, given reductions in cyclically adjusted deficits and the Stability and Growth Pact framework. - A few Directors argued for strict application of the Maastricht fiscal deficit criterion to protect credibility. - Challenges for successful monetary union during transition: - Improving Europe’s labor market performance critical. - Comprehensive labor market reforms would boost medium-term growth, improve fiscal performance, help adjust to adverse disturbances under monetary union, and increase public support. - Independence, mandate, and capacity of the European System of Central Banks to achieve price stability should be safeguarded. - Exchange rate not seen as a suitable nominal anchor for monetary policy in the euro area. - Introduction of the euro expected to accompany significant restructuring of financial markets and possible instability in money demand relationships. - ECB likely to use a wide range of indicators, especially in early stages of EMU; transparency of monetary policy important for credibility. - Despite fiscal consolidation progress, budgetary positions in many EU members might worsen medium to long term due to demographic developments; these problems must be addressed irrespective of EMU. - At their March 1998 discussion, Directors considered establishing a monetary union among a large number of EU member countries within reach per agreed timetable, but further fiscal consolidation desirable in the near term to strengthen medium-term growth potential and provide greater policy flexibility within the Stability and Growth Pact. - Directors expressed particular concern that structural reforms in labor and product markets were lagging. - Interim Committee in April 1998 requested the Executive Board to examine further the implications of EMU for IMF operations and for the conduct of IMF surveillance and to report in time for the Committee’s next meeting in October 1998. *Annual Report 1998 — International Capital Markets / The Global Economy (content unit).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/ar/98/pdf/_file02pdf.pdf_