## 1. Economic history—1971–—Periodicals.I. International

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### Assumptions and conventions used in the World Economic Outlook projections
- Real effective exchange rates assumed constant at their average levels during February 9–March 4, 1998, except for bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.
- Established policies of national authorities will be maintained (see Box 4 for specific fiscal and monetary policy assumptions in industrial countries).
- Average price of oil assumed to be $14.59 a barrel in 1998 and $15.94 a barrel in 1999, and remain unchanged in real terms over the medium term.
- Six-month LIBOR on U.S. dollar deposits assumed to average 6.1 percent in both 1998 and 1999.
- Estimates and projections are based on statistical information available at the end of March 1998.
- Conventions and notation:
  - . . . indicates data not available or not applicable;
  - — indicates the figure is zero or negligible;
  - – between years or months (for example, 1997–98 or January–June) indicates the years or months covered, including beginning and ending;
  - / between years or months (for example, 1997/98) indicates a fiscal or financial year.
  - “Billion” means a thousand million; “trillion” means a thousand billion.
  - “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to !/4of 1 percentage point).
- In figures and tables, shaded areas indicate IMF staff projections.
- Minor discrepancies between sums of constituent figures and totals are due to rounding.
- The term “country” may cover some territorial entities that are not states but for which statistical data are maintained separately.

### Preface — key context and outlook
- Financial turmoil in Asia that erupted in mid-1997 had abated since January (1998), with partial market recovery, but currency and asset values remained far below precrisis levels and considerable uncertainty persisted about crisis resolution and global repercussions.
- The crisis and likely effects were more severe than initially appeared; some downside risks identified in the December 1997 World Economic Outlook: Interim Assessment materialized.
- Projected global outcome:
  - World output growth in 1998 projected at just over 3 percent.
  - Previous projections: 3!/2percent in the December Interim Assessment and 4!/4percent in the October 1997 World Economic Outlook.
- Reasons cited for a relatively mild projected global slowdown:
  - Solid prospective growth of domestic demand in most industrial countries.
  - Limited spillover effects of the Asian crisis in other regions.
  - Medium-term projection that global economic growth would still exceed the average rate seen since 1970, reflecting continued strengthening in countries in transition and maintenance of relatively strong developing-world performance in the early and mid-1990s.

### Global outlook and near-term projections (Chapter II highlights)
- General projection:
  - The Asian crisis is expected to result in only a moderate and short-lived slowdown in world growth.
- Advanced economies:
  - Japan: overall activity is now projected to stagnate in 1998; further measures are urgently needed to bring about an early resumption of growth.
  - North America and western Europe: growth has been well sustained and appears likely to remain so in the period ahead.
- Emerging and transition countries:
  - Indonesia, Korea, and Thailand: drying up of private foreign financing, large currency depreciations, declines in asset prices, and sharp contractions of domestic demand; real GDP is likely to decline in the countries worst hit.
  - Malaysia, the Philippines, and other east Asian countries: lower near-term growth prospects on a smaller scale.
  - Contagion and spillovers have reduced availability of foreign financing, increased interest spreads on foreign borrowing, lowered stock market prices, and prompted policy tightenings that weaken near-term growth prospects widely.
  - In general, adverse effects on other emerging market and transition countries seem likely to be moderate, with growth remaining positive, but risks of a sharper slowdown exist if the crisis in Asia were to deepen.
- Commodity-price effects:
  - Weaker commodity prices, including for oil, affect terms of trade: net-importing developing and transition countries will have helpful terms of trade gains; many net exporters will face negative effects on growth, current account, and fiscal positions that will be significant in some cases.
- Balance of risks:
  - Downside risks from policy slippages, further financial-market unsettlement, and delayed recovery remain.

### Causes and dynamics of the Asian crisis
- Principal domestic factors:
  - Buildup of overheating pressures manifested in large external deficits and inflated property and stock market values.
  - Prolonged pegged exchange rate regimes, encouraging short-maturity external borrowing and excessive foreign-exchange risk exposure.
  - Financial-system weaknesses: weak management, poor control of risks, lax enforcement of prudential rules, inadequate supervision, relationship and government-directed lending.
  - Problems of data availability and lack of transparency.
  - Problems of governance and political uncertainties exacerbating the crisis of confidence.
- External factors:
  - Large private capital flows driven in part by underestimation of risks by international investors searching for higher yields amid low interest rates in Japan and Europe.
  - Wide swings in the yen/dollar exchange rate between 1994 and 1997 contributed to competitiveness losses associated with the dollar’s appreciation from mid-1995.
  - International investors—mainly commercial and investment banks, and in some cases hedge funds—contributed to downward pressure on crisis currencies; hedge funds appear to have played a significant role only in the case of the Thai bhat.

### Policy responses, IMF involvement, and adjustment requirements
- IMF and international community provided financial support for policy programs in Indonesia, Korea, and Thailand.
- Delays and hesitation in implementing reforms worsened the crisis by causing overshooting in currency and stock markets and exacerbating corporate and financial-sector difficulties.
- Policy cautions and guidance:
  - Countries with deteriorating external balances should avoid imposing barriers to trade or allowing competitive currency depreciations.
  - Monetary conditions in industrial countries may need to be somewhat easier in the period ahead than otherwise warranted, but policymakers must remain vigilant to prospective inflationary pressures arising from financial market developments and labor market pressures.

### Financial-market risks and advanced-economy developments
- Key points to monitor:
  - Equity markets in many countries have recently risen to new highs; the U.S. dollar has strengthened further.
  - The U.S. current account deficit is expected to widen substantially this year, creating potential for a future change in sentiment toward the dollar.
  - If commodity prices recover and labor-market pressures push up wage growth, the Federal Reserve could face the need for significant tightening of monetary conditions, potentially causing corrections in bond and stock markets.
  - Strength of sterling raises similar concerns for the United Kingdom.
- Financial-sector fragilities exist in many emerging market countries and in some advanced economies, especially Japan.

### Hedge funds: characteristics and role in recent market developments (Box 1 summary)
- Definition and scale:
  - Hedge funds are private investment pools, often domiciled offshore; typical U.S. funds offer private placements to fewer than 100 high-net-worth investors.
  - Typical compensation: a 1 percent management fee and 20 percent of profits.
  - Data suggest hedge fund capital was in the neighborhood of $100 billion as of the third quarter of 1997; about $25 billion of that was in macro funds.
  - Macro funds typically leverage their capital by borrowing by four to seven times.
  - By comparison, capital of other institutional investors in mature markets exceeds $20 trillion.
- Strategies and operational features:
  - Global macro funds seek countries where macro variables are far out of line with sustainable values.
  - Managers favor liquid markets and large positions when funding costs are low.
  - Most funds require advance notification for withdrawals: notice can vary from 30 days to three years.
  - Relative value funds tend to be more highly leveraged than macro funds.
- Regulatory and disclosure considerations:
  - Regulators in the United States and the United Kingdom see little need for a specialized policy response to regulate and limit hedge funds’ activities.
  - Possible limited measures: strengthen large-trader/position-reporting mechanisms; apply reporting across commercial banks, investment banks, insurance companies, and pension funds; raise margin and collateral requirements; restrict lending of domestic assets to nonresidents.
  - Caution: strong limits could prevent hedge funds from acting as contrarians and might not reduce volatility.

### Moral hazard and IMF lending (Box 2 summary)
- Definition and mandate:
  - Moral hazard: provision of insurance against a risk that encourages behavior making that risk more likely to occur.
  - IMF purpose (Article I): "To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards..."
- Observations on incentives and behavior:
  - It is considered hard to believe a country would deliberately risk a financial crisis because IMF assistance is available, given the huge costs of crises.
  - Between mid-1997 and early 1998 the value of foreign portfolio investments in some Asian markets "fell by half to two-thirds."
  - Trade shares: "trade with the Asian newly industrialized and developing economies (average of merchandise exports and imports) represented 7 percent of GDPin New Zealand, 8 percent of GDPin Australia, and 5 percent of GDPin Japan, compared with 1!/2–3  percent in the major industrial economies of Europe and North America."
- Short-term creditors and contagion:
  - Concern about moral hazard is greater for short-term international bank credit.
  - Example: provision of public funds "amounting to 6percent of GDP" to protect depositors of failed institutions and to recapitalize weak but solvent ones; initial round of capital injection completed at the end of March involving most major banks.
- Minimizing moral hazard—policy guidance:
  - Ensure private parties bear costs to the extent possible: close insolvent institutions, equity writedowns in restructured institutions, limited depositor protection as needed.
  - Consider “bail in” approaches so private creditors assume a greater share of the burden (as suggested by the Group of Seven communiqué of February 21, 1998).
  - Strengthen prudential management and supervision consistent with Basle Committee Core Principles and IMF frameworks.
  - Improve information collection, disclosure, and transparency; expand SDDS coverage and IMF transparency (Press Information Notices).

### Measures to reduce risk of crises — International monetary system (Box 3 summary)
- Macroeconomic policy and exchange-rate considerations:
  - Vulnerability escalates when domestic asset prices are inflated and capital inflows are short-term debt.
  - Greater exchange-rate flexibility may better suit many open developing economies.
- Second-generation reforms:
  - Emphasize broad structural reforms to sustain longer-run growth and reduce risk of disruptive investor confidence shifts (reduce government intervention, address corruption, improve budget transparency, strengthen financial sector).
- Surveillance:
  - Strengthen IMF surveillance via Article IV consultations; emphasize vulnerability to sudden capital flow shifts, dangers of short-term foreign currency debt, sound financial systems, and spillover risks.
  - Use regional groups for peer pressure; consider how surveillance messages are conveyed to markets and the public.
- Discipline on private capital flows:
  - Make suppliers and users of international capital flows more aware of risks; ensure debt flows and derivatives remain private obligations.
  - Prudential recommendations: limit short-term foreign currency exposure, improve national bankruptcy laws, establish expected loss sharing.
- Sovereign indebtedness:
  - Keep annual volume of sovereign debt maturing to manageable proportions; maintain adequate reserves; limit government obligations assumed as lender of last resort.
  - Consider contract provisions to encourage constructive creditor action in sovereign distress.

### Regional and country highlights (select excerpts)
- Japan:
  - Need for additional measures to make policy significantly stimulative this year; further land market and distribution system reforms recommended.
- Australia:
  - Inflation expected to remain within the official target range of 2–3 percent.
- New Zealand:
  - Current account deficit in 1997, at 7#/4percent of GDP, was the largest among the advanced economies.
- United States:
  - 1997 performance: fastest growth in 9 years; lowest inflation in 32 years (GDP deflator); unemployment at its lowest level in 24 years; virtual balance in the federal budget for the first time since the early 1970s.
- Latin America (selected):
  - Brazil: current account deficit likely to decline to 3!/4percent of GDP in 1998; growth expected to slow to 1!/2percent in 1998.
  - Argentina: growth in 1998 expected to moderate to 5!/2percent from 8 percent in 1997.
  - Mexico: growth projected to slow to about 4#/4percent in 1998; current account deficit projected to widen to 2!/2percent of GDP.
  - Chile: real GDP growth expected to moderate to 5!/2–6 percent in 1998.
  - Venezuela: growth expected to slow somewhat in 1998 owing to the drop in oil prices.
- Africa:
  - Estimated growth in 1997 revised down to 3!/4percent from 3#/4percent projected in October 1997.
  - South Africa: growth slowed to 1#/4percent in 1997 from 3#/4percent in 1996.
  - HIPC Initiative: Uganda expected to receive assistance this year; commitments made for Burkina Faso, Côte d’Ivoire, and Mozambique in 2000, 1999, and 2001, respectively.
- Countries in transition (select):
  - Russia: ruble under attack late October/November and late January; required: full and speedy implementation of fiscal action plan and tax code.
  - Ukraine: early strengthening of public finances is essential; structural banking weaknesses increased vulnerability.
  - Estonia: current account deficit 13percent of GDP in 1997; after fiscal tightening and bank prudential reinforcement markets stabilized.
  - Belarus: currency crisis in March 1998 following unsustainable credit expansion and external arrears.
  - Czech Republic, Hungary, Poland: relative resilience attributed to prior correction of macroeconomic imbalances; Hungary’s inflation was 18 percent in 1997.

### Fiscal policy, EMU convergence, and structural reform (Chapter III highlights)
- Italy achieved a deficit reduction equivalent to 4 percent of GDP last year.
- With little further consolidation projected for 1998–99 in most prospective EMU members:
  - Structural deficits are projected to remain close to or above 1 percent of GDP.
  - Actual deficits are projected to fall modestly below 3 percent of GDP.
- Medium-term fiscal guidance:
  - Most countries need to aim for medium-term fiscal positions at least in balance, with moderate surpluses likely needed to prepare for demographic change if relying on fiscal saving.
  - Of countries planning to join EMU in 1999, Finland, Ireland, and Luxembourg are expected to have underlying fiscal positions of balance or surplus in 1998.
  - For the other eight prospective participants, structural fiscal deficits are projected in the range of about 1–2!/2percent of GDP.
  - Denmark and Sweden have already achieved a structural budgetary surplus; the United Kingdom is expected to get very close to structural balance by 1998.
- Structural and labor-market concerns:
  - Lack of progress toward greater flexibility in product and labor markets remains a major concern and is described as the Achilles’ heel of the EMU project.
  - Recommended measures: reforms of tax and benefit systems, employment legislation, and training provisions to raise employment and improve incentives for job creation.
- EMU timetable and convergence:
  - On May 2, 1998, the Council of the European Union will decide which countries are qualified to participate in EMU.
  - Stage 3 due to begin on January 1, 1999 with exchange rates locked; decision on initial participants to be made in early May.
  - Inflation projected to rise by 2 percent a year in 1998–99 in the EU as a whole.
  - Maastricht reference values noted: deficit 3 percent of GDP; debt reference value of 60 percent of GDP.

*Source: World Economic Outlook (assumptions, preface, contributors, and chapter excerpts as provided in the content unit).*

### 1. Economic history—1971–—Periodicals.I. International

### _0598ch1pdf - 1. Economic history—1971–—Periodicals.I. International

### Assumptions and conventions used in the World Economic Outlook projections
- Real effective exchange rates assumed constant at their average levels during February 9–March 4, 1998, except for bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.
- Established policies of national authorities will be maintained (see Box 4 for specific fiscal and monetary policy assumptions in industrial countries).
- Average price of oil assumed to be $14.59 a barrel in 1998 and $15.94 a barrel in 1999, and remain unchanged in real terms over the medium term.
- Six-month LIBOR on U.S. dollar deposits assumed to average 6.1 percent in both 1998 and 1999.
- Estimates and projections are based on statistical information available at the end of March 1998.
- Conventions:
  - . . . indicates data not available or not applicable;
  - — indicates the figure is zero or negligible;
  - – between years or months (for example, 1997–98 or January–June) indicates the years or months covered, including beginning and ending;
  - / between years or months (for example, 1997/98) indicates a fiscal or financial year.
  - “Billion” means a thousand million; “trillion” means a thousand billion.
  - “Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are equivalent to !/4of 1 percentage point).
- In figures and tables, shaded areas indicate IMF staff projections.
- Minor discrepancies between sums of constituent figures and totals are due to rounding.
- The term “country” may cover some territorial entities that are not states but for which statistical data are maintained separately.

### Preface — key context and outlook
- Financial turmoil in Asia that erupted in mid-1997 had abated since January (1998), with partial market recovery, but currency and asset values remained far below precrisis levels and considerable uncertainty persisted about crisis resolution and global repercussions.
- The crisis and likely effects were more severe than initially appeared; some downside risks identified in the December 1997 World Economic Outlook: Interim Assessment materialized.
- The projected global outcome was a slowdown in economic growth that would be much less pronounced than the slowdowns of 1974–75, 1980–83, and 1990–91 (see Figure 1).
- Reasons given for a relatively mild projected global slowdown:
  - Solid prospective growth of domestic demand in most industrial countries.
  - Limited spillover effects of the Asian crisis in other regions.
  - Medium-term projection that global economic growth would still exceed the average rate seen since 1970, reflecting continued strengthening in countries in transition and maintenance of relatively strong developing-world performance in the early and mid-1990s.
- World Economic Outlook projections noted:
  - World output growth in 1998 projected at just over 3 percent.
  - Previous projections: 3!/2percent in the December Interim Assessment and 4!/4percent in the October 1997 World Economic Outlook (see Table 2).

### Scope, methodology, and contributors
- The World Economic Outlook is an element of IMF surveillance of economic developments and policies in member countries and the global economic system.
- Published annually from 1980 through 1983 and biannually since 1984.
- Survey draws primarily on information gathered through IMF consultations, carried out by area departments together with the Policy Development and Review Department and the Fiscal Affairs Department.
- Country projections:
  - Prepared by IMF area departments using internationally consistent assumptions about world activity, exchange rates, and conditions in international financial and commodity markets.
  - For approximately 50 of the largest economies (accounting for 90 percent of world output), projections are updated for each WEO exercise.
  - For smaller countries, projections are based on those prepared at the time of the IMF’s regular Article IV consultations or in connection with the use of IMF resources, and are incrementally adjusted to reflect changes in assumptions and global conditions.
- Coordination and leadership:
  - General direction by Michael Mussa, Economic Counsellor and Director of Research.
  - Project directed by Flemming Larsen, Deputy Director of the Research Department, together with Graham Hacche, Assistant Director for the World Economic Studies Division.
- Primary contributors to the issue include Francesco Caramazza, John H. Green, Staffan Gorne, Mark De Broeck, Paula De Masi, Jahangir Aziz, Ramana Ramaswamy, Ranil Salgado, Phillip Swagel, and Cathy Wright.
- Other contributors include Susan J. Adams, Barry Eichengreen, Peter Isard, George Kopits, Thomas Krueger, Douglas Laxton, Donogh McDonald, Guy Meredith, Gian Maria Milesi-Ferretti, Ceyla Pazarbasioglu, Blair Rourke, and Andrew Tweedie.
- Fiscal Analysis Division of the Fiscal Affairs Department computed structural budget and fiscal impulse measures.
- Research assistance provided by Sungcha Hong Cha, Jeffrey Gable, Gretchen Gallik, Mandy Hemmati, and Anthony G. Turner.
- Data processing and computer systems managed by Allen Cobler, Nicholas Dopuch, Isabella Dymarskaia, Yasoma Liyanarachchi, and Olga Plagie.
- Word processing by Susan Duff, Caroline Bagworth, Margaret Dapaah, and Lisa Marie Scott-Hill.
- Manuscript editing and production coordination by James McEuen of the External Relations Department.
- Analysis benefited from comments by IMF staff and Executive Directors following discussion of the WEO on March 25 and 27, 1998; projections and policy considerations are those of IMF staff and should not be attributed to Executive Directors or national authorities.

### Organizational structure and major chapters (high-level)
- Chapter I: Global Economic Prospects and Policy Considerations — sections include The Asian Crisis; Advanced Economies; Developing Countries; Countries in Transition; Appendix on EMU convergence challenges.
- Chapter II: Global Repercussions of the Asian Crisis and Other Issues — covers global growth outlook, inflation/deflation prospects, currency realignments, global flows of funds and current account balances, outlook for Japan, emerging market issues.
- Chapter III: The Business Cycle, International Linkages, and Exchange Rates — business cycles, relationship between business cycles and exchange rates, policy and surveillance implications.
- Chapter IV: Financial Crises — types, identification, origins, contagion, indicators of vulnerability, stylized macro behavior, early warning signals.
- Chapter V: Progress with Fiscal Reform in Countries in Transition — stabilization to sustainability, revenue and expenditure, intergovernmental fiscal relations, legal reform, transparency, accountability.
- Annexes, boxes, statistical appendix, tables, and figures provide detailed data, indicators, and country-specific analyses.

*Source: World Economic Outlook (assumptions, preface, contributors, and table of contents as provided in the content unit).*

### Chapter II). The largest downward revisions have been

### _0598ch1pdf - Chapter II). The largest downward revisions have been

### Global outlook and near-term projections
- The Asian crisis is expected to result in only a moderate and short-lived slowdown in world growth.
- Advanced economies:
  - Japan: overall activity is now projected to stagnate in 1998; further measures are urgently needed to bring about an early resumption of growth.
  - North America and western Europe: growth has been well sustained and appears likely to remain so in the period ahead.
- Emerging and transition countries:
  - The three economies most affected—Indonesia, Korea, and Thailand—are experiencing drying up of private foreign financing, large currency depreciations, declines in asset prices, and sharp contractions of domestic demand; real GDP is likely to decline in the countries worst hit.
  - Malaysia, the Philippines, and a number of other east Asian countries have had lower near-term growth prospects on a smaller scale.
  - Contagion and spillover effects have reduced availability of foreign financing, increased interest spreads on foreign borrowing, lowered stock market prices, and prompted policy tightenings that weaken near-term growth prospects widely.
  - In general, adverse effects on other emerging market and transition countries seem likely to be moderate, with growth remaining positive, but there are risks of a sharper slowdown if the crisis in Asia were to deepen.
- Commodity price effects:
  - Weaker commodity prices, including for oil, are affecting terms of trade: net-importing developing and transition countries will have helpful terms of trade gains; many net exporters will face negative effects on growth, current account, and fiscal positions that will be significant in some cases.
- Balance of risks:
  - Although the threat to global growth from the Asian crisis still appears limited, clear downside risks exist from policy slippages, further financial-market unsettlement, and delayed recovery.

### Causes and dynamics of the Asian crisis
- Principal domestic factors contributing to the deterioration in investor sentiment:
  - Buildup of overheating pressures manifested in large external deficits and inflated property and stock market values.
  - Maintenance for too long of pegged exchange rate regimes, complicating monetary responses to overheating and encouraging short-maturity external borrowing and excessive foreign-exchange risk exposure.
  - Financial-system weaknesses: weak management, poor control of risks, lax enforcement of prudential rules, inadequate supervision, relationship and government-directed lending leading to sharp deterioration in banks’ loan portfolios.
  - Problems of data availability and lack of transparency, hindering realistic market assessments and adding to uncertainty.
  - Problems of governance and political uncertainties exacerbating the crisis of confidence and the reluctance of foreign creditors to roll over short-term loans.
- External factors:
  - Large private capital flows driven in part by underestimation of risks by international investors searching for higher yields amid low interest rates in Japan and Europe.
  - Wide swings in the yen/dollar exchange rate between 1994 and 1997 contributed to competitiveness losses associated with the dollar’s appreciation from mid-1995, contributing to export slowdowns in 1996–97.
  - International investors—mainly commercial and investment banks, and in some cases hedge funds—contributed to downward pressure on crisis currencies; hedge funds appear to have played a significant role only in the case of the Thai bhat.

### Policy responses, IMF involvement, and adjustment requirements
- Countries directly affected have needed to implement corrective measures; the international community led by the IMF has provided financial support for policy programs in Indonesia, Korea, and Thailand.
- Delays and initial hesitation by authorities in implementing reforms and confidence-repairing measures worsened the crisis by causing overshooting in currency and stock markets, exacerbating panic, and adding to corporate and financial-sector difficulties.
- Important policy cautions:
  - Countries whose external balances deteriorate should avoid imposing barriers to trade or allowing competitive currency depreciations; such defensive reactions would be counterproductive and slow adjustment.
  - Monetary conditions in industrial countries may need to be somewhat easier in the period ahead than otherwise warranted, but policymakers must remain vigilant to prospective changes in inflationary pressure arising from financial market developments and labor market pressures.

### Risks from financial markets and advanced-economy developments
- Financial-market developments to monitor:
  - Equity markets in many countries have recently risen to new highs; the U.S. dollar has strengthened further.
  - The U.S. current account deficit is expected to widen substantially this year, creating potential for a future change in sentiment toward the dollar that could reverse temporary factors holding down U.S. inflation.
  - If world commodity prices recover and labor-market pressures push up wage growth, the Federal Reserve could face the need for significant tightening of monetary conditions, potentially causing corrections in bond and stock markets.
  - Strength of sterling points to similar concerns for the United Kingdom.
- Financial-sector fragilities exist in many emerging market countries and in some advanced economies, especially Japan.

### Lessons drawn and areas for deeper analysis in this issue
- This issue of the World Economic Outlook:
  - Extends and updates the Interim Assessment of the global ramifications of the Asian crisis (Chapter II).
  - Draws broader lessons from recent and earlier financial crises (Chapter IV).
  - Examines how exchange rate developments among major currencies relate to international divergences in business cycles (Chapter III).
  - Considers aspects of the scheduled start of Stage 3 of European Economic and Monetary Union (EMU).
  - Examines progress with fiscal reform in transition countries (Chapter V).

### Hedge funds: characteristics and role in recent market developments (summary)
- Definition and scale:
  - Hedge funds are private investment pools, often domiciled offshore; typical U.S. funds offer private placements to fewer than 100 high-net-worth investors to use regulatory exemptions.
  - Typical compensation: a 1 percent management fee and 20 percent of profits.
  - Data suggest hedge fund capital was in the neighborhood of $100 billion as of the third quarter of 1997; about $25 billion of that was in macro funds.
  - Macro funds typically leverage their capital by borrowing by four to seven times.
  - By comparison, capital of other institutional investors in mature markets exceeds $20 trillion.
- Common characteristics of strategies:
  - Global macro funds seek countries where macro variables are far out of line with sustainable values to realize large asset-price changes.
  - Managers are attracted to investments where the risk of large capital losses is effectively nil (for example, an exchange rate perceived as certain to be devalued but not revalued).
  - Hedge funds are most likely to take large positions when the cost of funding is low.
  - Managers favor liquid markets where large trades can be executed at low cost.
- Operational features:
  - Most funds require advance notification for withdrawals: notice can vary from 30 days for funds with more liquid investments to three years for other funds.
  - Relative value funds tend to be more highly leveraged than macro funds because the capital needed to establish positions is relatively small on the instruments they hold.
- Contextual note:
  - Other investors and institutional entities (mutual funds, pension funds, insurance companies, investment and commercial banks) engage in many similar practices; hedge funds are large but small relative to overall institutional investor capital in mature markets.

*Italic: International Monetary Fund — World Economic Outlook chapter excerpt.*

### Box 1.The Role of Hedge Funds in Financial Markets

### Box 1. The Role of Hedge Funds in Financial Markets

### Constraints on hedge fund activity in smaller and emerging markets
- Limited size of accepted deals can constrain hedge funds and other investors who attempt to build up positions.
- Capital controls or restrictions on domestic banks doing business with offshore counterparties make it difficult for hedge funds to put on positions relative to commercial and investment banks that operate both offshore and onshore.
- Managers are wary of being identified as being on the other side of the government’s or central bank’s transactions; anonymity is particularly difficult to maintain in smaller, less liquid markets.

### Do hedge funds lead other investors?
- Evidence is scanty and mixed.
- Analysis of data reported to the U.S. Commodity Futures Trading Commission by broker-dealers, commercial banks, foreign banks, hedge funds, insurance companies, mutual funds, pension funds, and savings and loans found:
  - Hedge funds herd among themselves in the Standard and Poor’s 500 index contract and the three-month Eurodollar contract.
  - Smaller funds were detected as herding with larger ones in the Japanese yen contract and the Standard and Poor’s 500 Index contract.
- An extension testing whether hedge funds lead other categories of investors obtained mixed results:
  - There is a negative correlation between the positions of hedge funds and the positions of other institutional traders in the same period.
  - There is little correlation between the positions of hedge funds in the immediate past period and the current positions of other traders.

### Regulatory and disclosure considerations
- Regulators in the United States and the United Kingdom see little need for a specialized policy response to regulate and limit hedge funds’ activities to increase financial market stability.
- Prevailing view: hedge funds that take short positions against foreign currencies often do so in response to evidence of inconsistent policies likely to render currency pegs unsustainable.
- Hedge funds can act as sources of liquidity and stabilizing speculation when they buy sharply depreciated currencies after a speculative crisis.
- Possible limited measures to strengthen supervision, regulation, and market transparency:
  - Strengthen and replicate large-trader and position-reporting mechanisms (as in countries like the United States) to render hedge fund operations more transparent.
  - Any system of detailed portfolio and position reporting would need to encompass commercial banks, investment banks, insurance companies, and pension funds as well.
  - Reporting requirements would have to be applied by all countries; otherwise, market participants could book transactions offshore.
  - Limit hedge fund positions by requiring banks and brokers to raise margin and collateral requirements.
  - Restrict the ability of financial institutions to lend domestic assets to nonresidents to limit short positions in currency markets.
- Caution on strong limits:
  - Strong limits on position-taking could prevent hedge funds and other international investors from acting as contrarians.
  - Hedge funds may be among the first to short a currency when fundamentals appear inconsistent and among the first buyers after a crisis when a depreciating currency overshoots.
  - It is not clear that discouraging position-taking by hedge funds would reduce volatility in currency or other asset markets.

### Broader policy implications for countries facing speculative pressure
- Most important actions for policymakers:
  - Avoid offering one-way bets through inconsistent policies and indefensible currency pegs.
  - Strengthen clearance, settlement, and payments systems to withstand asset-price volatility.
  - Provide better information about government policy and private sector financial conditions to weaken herd behavior among inadequately informed investors.

### Empirical and contextual findings summarized in the box and surrounding text
- The box cites empirical findings of herding in specific futures contracts (Standard and Poor’s 500, three-month Eurodollar, Japanese yen).
- Surrounding chapter text (contextual to the Asian crisis) notes:
  - For 1998 as a whole, the aggregate current account of Indonesia, Malaysia, the Philippines, Thailand (the ASEAN-4 countries), and Korea is now expected to be in surplus by about $20 billion, compared with deficits of $27 billion in 1997 and $54 billion in 1996.
  - Output is still expected to decline in Indonesia, Korea, and Thailand in 1998.
  - As needed policies are implemented and external positions improve, confidence should recover gradually during 1998, paving the way for a moderate rebound in growth in 1999 and solid recovery by 2000.
  - The chapter emphasizes the importance of identifying weaknesses early, developing and monitoring early-warning indicators of vulnerability, and considering exchange rate regime adjustments where appropriate.

*Box 1. The Role of Hedge Funds in Financial Markets, IMF*

### Box 2.Moral Hazard and IMFLending

### Box 2.Moral Hazard and IMFLending

### Definition and IMF mandate
- Moral hazard: provision of insurance against a risk that encourages behavior making that risk more likely to occur.
- Concern in IMF lending: availability of financial assistance may weaken policy discipline of borrowers, encourage international investors to take greater risks believing they will only partially suffer consequences, or both.
- Fundamental purpose of the IMF (Article I of its Articles of Agreement) includes: "To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity."
- Rationale for IMF lending role: limit economic and social costs of crises; avoid unnecessarily deep and damaging crises and global contagion as taught by the experience of the Great Depression.

### Borrowers, lenders, and empirical observations
- Borrower incentives:
  - It is considered hard to believe a country would deliberately risk a financial crisis simply because it can count on IMF assistance, given huge economic, social, and political costs of crises and required reforms.
  - Repeated failure to request early assistance is a concern; delays likely reflect political reluctance to accept policy changes rather than moral hazard.
- Investors and long-term creditors:
  - International equity investors and holders of long-term debt instruments do not appear substantially motivated by prospects of international rescue.
  - Between mid-1997 and early 1998 the value of foreign portfolio investments in some Asian markets "fell by half to two-thirds."
  - Bond investors do not expect compensation for the immediate consequences of a crisis.
- Trade statistic preserved in source text:
  - "trade with the Asian newly industrialized and developing economies (average of merchandise exports and imports) represented 7 percent of GDPin New Zealand, 8 percent of GDPin Australia, and 5 percent of GDPin Japan, compared with 1!/2–3  percent in the major industrial economies of Europe and North America."

### Short-term creditors, contagion, and financial-sector moral hazard
- Greater concern exists for moral hazard in short-term credit provided by international banks and other investors.
- Governments sometimes provide extensive guarantees to banks’ external creditors to convince them to roll over short-term claims (as in several Asian countries in crisis); even then, foreign banks are not completely protected and some claims are typically written down.
- Evidence of cost to international banks: fall in earnings and increase in loan-loss provisions in the fourth quarter of 1997 for banks heavily exposed to Asian emerging markets.
- Example of domestic policy action cited:
  - provision of public funds "amounting to 6percent of GDP" to protect depositors of failed institutions and to recapitalize weak but solvent ones; initial round of capital injection completed at the end of March involving most major banks, though conditions were "not very stringent."

### Minimizing moral hazard: policies, supervision, and information
- Core principle: ensure private parties to transactions bear the costs of their actions to the extent possible.
  - Banking sector restructuring advice typically includes closing insolvent institutions and equity writedowns in restructured institutions.
  - Depositors may need protection up to certain limits or more broadly if there is a genuine risk of a run on entire banking systems.
  - For banks’ foreign creditors, avoiding moral hazard altogether may be difficult, but arrangements where foreign banks agree to roll over short-term loans at reasonable risk premia could be feasible.
  - The "bail in" issue—private creditors assuming a greater share of the burden—needs careful consideration, as suggested by the Group of Seven (communiqué following meeting on February 21, 1998).
- Prudential management and supervision:
  - Adherence to principles of sound banking is essential: adequate capitalization, regulation, shareholders and subordinated creditors bearing main consequences of imprudent decisions.
  - Key elements of reform (as outlined in the Basle Committee’s Core Principles and IMF frameworks) include recognition and disclosure standards for gains and losses, adequate capitalization, strict limitation of public sector support in systemic need, clear early-exit policy for insolvent institutions, and autonomy of bank regulation from political interference.
  - Special attention warranted for systemic risks from large-scale, short-term, foreign currency borrowing.
- Information collection, disclosure, and transparency:
  - Financial markets rely on information; poor information, limited disclosure, or disguised information increases vulnerability and disruptive behavior.
  - Improvements require private-sector implementation of sound accounting practices and disclosure standards; governments must promote these practices and collect and disseminate accurate economic and financial data with adequate detail and timeliness.
  - Central government responsibility: provision of comprehensive and transparent fiscal accounts; room for improvement in many countries.
  - Need to improve compilation of financial data, particularly data on external indebtedness and its maturity.
  - IMF initiatives: creation of a voluntary Special Data Dissemination Standard (SDDS) for countries currently or prospectively borrowing on international capital markets; efforts to improve SDDS coverage of international reserves, add prudential-type bank indicators, and specify private external debt more clearly.
  - IMF steps to increase its own transparency include the introduction of Press Information Notices.

### Policy recommendations and reform areas
- Seek to minimize moral hazard without eliminating it at the cost of substantially higher economic and social costs of crises.
- Policy ingredients to lift economies (example context in source text):
  - Maintain easy monetary conditions where justified by negligible underlying inflation, large output gap, weak demand, weak credit growth, and risk of a "credit crunch"; consider using limited scope to reduce official interest rates further and ensure ample liquidity.
  - Financial-sector policies: restore confidence and raise banks’ willingness to lend; use public funds with rules-based and transparent criteria to ensure assisted banks take necessary steps for long-term viability; follow with medium-term steps to foster a competitive, dynamic, market-based financial system.
  - Fiscal policy: ensure it supports growth when needed while maintaining medium-term fiscal consolidation; the source text notes a contractionary fiscal stance "to the tune of about !/2of  1  percent  of GDP" in the budget for the year discussed.
- Broader reform priorities to reduce frequency and costs of crises:
  - Improve information practices, disclosure, and transparency.
  - Strengthen prudential regulation and supervision of financial institutions.
  - Consider orderly approaches to capital account liberalization, with attention to sequencing and financial system preparedness.

*Box 2. Moral Hazard and IMF Lending*

### Box 3.International Monetary System: Measures to Reduce the Risk of Crises

### Box 3.International Monetary System: Measures to Reduce the Risk of Crises

### Macroeconomic Policies
- Generally sound management of monetary and fiscal policy provides no absolute guarantee against major economic crises.
- Substantial current account deficits and overvalued exchange rates can develop despite prudent macroeconomic policies.
- Vulnerability escalates when domestic asset prices are inflated and capital inflows take the form of short-term debt.
- Key resilience factors:
  - Capacity for macro policies to react quickly and credibly to threats.
  - Resilience of the economy, especially the financial sector, to firming of monetary and fiscal policy.
  - Political willingness to tighten policies when needed.
- Exchange rate considerations:
  - Many countries have benefited from fixed exchange rates; increasingly, developing countries have shifted to floating regimes, often with intervention.
  - Greater openness implies more countries may wish to reconsider whether regimes with greater exchange rate flexibility (and greater flexibility in other policies) better suit their needs.
  - The exchange rate must remain a key concern of economic policy.
  - Emerging markets with flexible exchange rate systems need to be prepared to adjust policies readily to limit exchange rate volatility.

### Second-Generation Reforms
- Broadly based structural reforms—so-called second-generation reforms—are essential to:
  - Sustain and enhance longer-run growth performance.
  - Reduce the risk of disruptive changes in investor confidence when problems appear.
  - Enhance the credibility of policy actions needed to forestall or contain crises.
- Areas highlighted by recent Asian crises include:
  - Reducing government intervention where market forces provide greater efficiency.
  - Measures to address corruption and improve private and public sector governance.
  - Improved transparency of government budgets (see Annex I).
  - Strengthened efficiency and robustness of the financial sector.

### Surveillance
- Diagnosis of vulnerabilities and prescription of remedies can be aided by surveillance from the IMF, other multilaterals, and regional/country groups.
- IMF surveillance mainly occurs through the annual Article IV consultation with each member country:
  - Article IV staff report is based on IMF staff research and discussions with country authorities.
  - The report is presented to and discussed by the IMF’s Executive Board, whose 24 members represent the institution’s 182 member countries.
- Recent events suggest surveillance should emphasize:
  - Vulnerability to sudden shifts in international capital flows.
  - Particular dangers of short-term foreign currency debt.
  - Importance of sound financial systems and their informational infrastructure.
  - Potential for spillover and contagion effects.
- To strengthen surveillance effectiveness:
  - Regional groups can provide peer pressure for early problem-addressing.
  - Strengthen incentives for national authorities to heed surveillance messages while problems remain manageable.
  - Consider how messages from surveillance should be conveyed to financial markets and the public.
  - Introduction of Press Information Notices allows IMF members to release the IMF Executive Board’s assessment following an Article IV consultation.

### Discipline on Private Capital Flows
- Surges of capital to emerging markets have contributed to unsustainable booms; rapid reversals have precipitated crises.
- Desirable measures:
  - Make suppliers and users of international capital flows more aware of risks; ensure they jointly bear principal cost of a crisis if one occurs.
  - Equity capital flows present limited problems; debt flows and derivative transactions with private entities should remain private obligations resolved by established mechanisms.
- Prudential policy recommendations:
  - Prudential regulations to limit short-term (especially foreign currency) exposure—particularly for the financial sector where government may need to act as lender of last resort.
  - National bankruptcy laws to facilitate appropriate loss sharing.
  - Establish losses to private borrowers and lenders as a regular and expected event when defaults occur to promote proper risk appreciation and prudent management.
- Moral hazard and crisis resolution:
  - To contain moral hazard, governments should avoid general bailouts of private creditors or private debtors in a general crisis.
  - Mechanisms to facilitate private creditor participation in expeditious resolution, including appropriate loss sharing, would be desirable but are difficult to design and implement.
  - The premium is on avoiding systemic crises.

### Sovereign Indebtedness
- Default by a sovereign borrower poses particularly great difficulties; no established expeditious mechanism exists.
- Contemporary concerns:
  - Sovereign debt is often in the form of bonds held by widely diversified investors, making messy approaches less manageable.
- Key requirements to contain sovereign debt problems:
  - Keep the volume of sovereign debt, especially foreign currency debt, falling due in any year to manageable proportions.
  - Maintain adequate foreign currency reserves.
  - Limit, through prudential regulations and liquidity requirements, obligations the government might assume as lender of last resort in a systemic banking crisis.
- Legal and contractual considerations:
  - Heightened danger of litigation after default underscores caution in waiving sovereign immunities, particularly by central banks.
  - Consider provisions in new loan contracts and bond covenants to encourage constructive collection action by creditors when a sovereign faces grave difficulties in meeting obligations (as suggested by the report of the Deputies of the Group of Ten on The Resolution of Sovereign Liquidity Crises).

### Regional and Country Notes (select highlights)
- Japan:
  - Need for additional measures to make policy significantly stimulative this year.
  - Tax reductions financed by base broadening and spending cuts when recovery is firmer would promote medium-term structural reform objectives and provide short-term stimulus.
  - Additional public expenditure should be efficiently used and boost productive potential.
  - More rapid structural reform action is overdue to improve medium-term growth potential and to promote recovery by increasing confidence and opening new investment areas.
  - Economic package announced in November reinforced earlier initiatives with deregulation measures affecting telecommunications and land use.
  - Further land market reforms would support efforts to strengthen banks’ financial position; further reforms of the distribution system are needed to open the economy further.
- Australia:
  - Growth strengthened during 1997 with subdued inflation, a budget close to balance, and a reduced current account deficit.
  - Australian dollar depreciated sharply in late 1997, retraced some in early 1998; depreciation will attenuate crisis effects on net exports and growth.
  - Inflation expected to remain within the official target range of 2–3 percent.
  - Widening of the current account deficit is likely; maintenance of fiscal consolidation remains appropriate, allowing automatic stabilizers to absorb crisis effects.
- New Zealand:
  - Monetary policy must balance supporting growth pickup and limiting potential inflation from currency weakness.
  - Current account deficit in 1997, at 7#/4percent of GDP, was the largest among the advanced economies; fiscal tightening measures may be necessary to achieve projected budget surpluses and help maintain investor confidence.
- Hong Kong SAR:
  - Competitiveness deteriorated due to regional currency depreciations; interest rates have risen periodically under currency pressure.
  - Corrections in equity and property markets, higher interest rates, and weaker external demand will slow activity in 1998.
  - Maintenance of the peg under the currency board arrangement is facilitated by flexible product and factor markets and a strong international reserve position; banking sector strains are present but fundamentals and regulatory framework are strong.
- United States:
  - 1997 performance: fastest growth in 9 years; lowest inflation in 32 years (in terms of the GDP deflator); unemployment at its lowest level in 24 years; virtual balance in the federal budget for the first time since the early 1970s.
  - Current stance of monetary policy seems appropriate; further adjustment should await signs of continuing above-potential growth or an unexpectedly sharp slowdown.
  - Importance of allowing small fiscal surpluses for 1998–99 to materialize and accelerating entitlement reform to improve the fiscal position ahead of deterioration expected next decade.
- Canada:
  - Strong growth in 1997; inflation eased further; widening current account deficit and weak commodity markets contributed to downward pressure on the Canadian dollar intensified by the Asian crisis.
  - Official interest rates raised in November and December 1997 and in January 1998 to offset currency depreciation effects.
  - IMF staff project surpluses for 1998/99 and beyond; given subdued inflation and output gap, altering monetary conditions is not warranted unless expansion becomes robust and inflation risks rise.
- Europe:
  - Notable divergences in cyclical positions across countries.
  - Group 1 (United Kingdom, Denmark, Finland, Ireland, the Netherlands, Norway): strong expansions continued with subdued inflation; key challenge to reduce risk of overheating.
  - United Kingdom specifics: above-potential growth reduced unemployment to a 17-year low; inflation near 2!/2percent target though earnings growth picked up; trade weakening and domestic demand strong—monetary policy balance is challenging.
  - Group 2 (Germany, France, Italy): growth strengthened moderately since early 1997; key challenge to maintain momentum through stronger domestic demand given high unemployment rates.
  - Switzerland: begun to recover from six years of stagnation; supportive monetary conditions needed.
  - Portugal and Spain: enjoying strong growth; prospective easing in run-up to EMU should not give immediate concern.
  - EMU implications:
    - Stage 3 due to begin on January 1, 1999 with exchange rates locked; decision on initial participants to be made in early May.
    - Prospect of continued convergence of interest rates among prospective participants with scope for some further decline in average short-term rates.

*Source: Box 3. International Monetary System: Measures to Reduce the Risk of Crises (excerpt).*

### Chapter III).

### Chapter III)

### Fiscal Policy and EMU Convergence
- Italy achieved a deficit reduction equivalent to 4 percent of GDP last year.
- With little further consolidation projected for 1998–99 in most prospective EMU members:
  - Structural deficits are projected to remain close to or above 1 percent of GDP.
  - Actual deficits are projected to fall modestly below 3 percent of GDP.
- Implications and policy recommendations:
  - Several countries will enter EMU with fiscal positions that circumscribe the scope for flexibility under the Stability and Growth Pact.
  - Need for further budgetary consolidation, taking advantage of present favorable cyclical conditions to move decisively.
  - Prospective costs of population aging reinforce the need for consolidation.
  - Consolidation should be accompanied by reforms of benefits, subsidies, and taxes to raise employment and improve economic efficiency.
- Medium-term fiscal guidance:
  - Most countries need to aim for medium-term fiscal positions at least in balance, with moderate surpluses likely needed if they prepare for demographic change via fiscal saving rather than pension reform.
  - Of the countries planning to join EMU in 1999, Finland, Ireland, and Luxembourg are expected to have underlying fiscal positions of balance or surplus in 1998.
  - For the other eight prospective participants, structural fiscal deficits are projected in the range of about 1–2!/2percent of GDP.
  - Denmark and Sweden have already achieved a structural budgetary surplus; the United Kingdom is expected to get very close to structural balance by 1998.

### Structural Policies and Labor Markets
- Assessment of structural reform:
  - Lack of progress toward greater flexibility in product and labor markets remains a major concern across most prospective participating countries, including the three largest.
  - Poorly functioning labor markets will impede reductions in high unemployment and will hinder macroeconomic adjustment under a single currency, tending to produce further increases in joblessness.
  - The failure to reform Europe’s labor markets is described as the Achilles’ heel of the EMU project.
- Recommended structural measures:
  - Reforms of tax and benefit systems, employment legislation, and training provisions to enhance labor supply and mobility and improve incentives for job creation.
  - Avoid measures that might worsen structural unemployment, such as legislated reductions in work weeks and increases in minimum wages.

### Developing Countries — Regional Impacts of the Asian Crisis
- General outlook:
  - Developing countries in all regions are adversely affected to varying degrees by the Asian crisis.
  - Most developing countries are likely to experience at least moderate slowdowns in growth in 1998 due to high risk premia, losses of competitiveness, lower commodity prices, and efforts to address domestic and external imbalances.
- China:
  - Capital inflows consist primarily of direct investment; vehicles for financial speculation are limited.
  - The real effective exchange rate has risen somewhat (by about 6 percent).
  - Trade position remains strong; international reserves are large.
  - Growth expected to slow moderately in 1998 due to weakening domestic demand and a more difficult international environment.
  - Authorities are committed not to devalue the renminbi.
  - Key policy challenges: restructure and enhance efficiency in state enterprises (including diversifying ownership) and strengthen the banking system.
- India:
  - The rupee has fallen by about 10 percent against the U.S. dollar since late 1997, but its exchange value is little changed on a real multilateral basis.
  - Capital inflows are expected to be sustained; considerable potential for higher foreign direct investment remains.
  - Recent slowing of growth suggests that the boost from reforms initiated in 1991 has been wearing off.
  - Needed actions to put India on a sustainably faster growth path: reduce the large fiscal deficit, liberalize foreign trade and investment, alleviate infrastructure bottlenecks, deregulate domestic product markets, and reform the financial and enterprise sectors.
- Pakistan:
  - External position remains fragile; strong adjustment efforts are needed to reinforce benefits of structural reforms.
- Latin America:
  - Brazil:
    - Tightened monetary and fiscal policies in October and November restored market confidence and halted reserve drains.
    - Further privatizations should help maintain capital inflows.
    - Current account deficit likely to decline to 3!/4percent of GDP in 1998; growth expected to slow to 1!/2percent in 1998.
    - Continued efforts to contain fiscal and external imbalances are needed.
  - Argentina:
    - Financial market pressures emerged in October with a significant stock market correction and widening sovereign spreads.
    - Financial conditions have eased; growth in 1998 is expected to moderate to 5!/2percent from 8 percent in 1997.
    - Current account deficit projected to widen further—an element of vulnerability.
  - Mexico:
    - Asian crisis led to marked increase in exchange market and interest rate volatility.
    - Temporary increase in interest rates helped stabilize the exchange rate; the peso fell to new lows against the dollar in February.
    - Growth projected to slow moderately to about 4#/4percent in 1998.
    - Current account deficit projected to widen to 2!/2percent of GDP.
  - Chile:
    - Peso pressured in December, stabilized by late January after official intervention and a sizable interest rate increase.
    - Real GDP growth expected to moderate slightly to 5!/2–6 percent in 1998, with further easing of inflation.
    - Current account deficit projected to widen because of Asian slowdown effects on export earnings.
  - Venezuela:
    - Economic recovery gained momentum in 1997 with real GDP expanding by 5 percent.
    - Progress in reducing inflation has been slower than expected due to limited fiscal adjustment and insufficiently tight monetary policy.
    - Growth expected to slow somewhat in 1998 owing to the drop in oil prices.
  - Bolivia and Guyana:
    - Expected to receive assistance this year under the HIPC Initiative.
- Middle East and Europe (non-EU region):
  - Direct spillovers from the Asian crisis have been limited to temporary declines in equity prices and wider spreads on internationally traded debt.
  - A sustained decline in oil prices would pose a serious risk to growth for the region, especially large oil exporters like Saudi Arabia and Kuwait.
  - Islamic Republic of Iran: real GDP expansion slowed last year; growth expected to remain subdued in 1998 partly because of lower oil prices.
  - Turkey: growth moderated to 5#/4percent in 1997, expected to slow further in 1998 as the government tightens policy to reduce inflation running close to triple digits annually; continuing large fiscal deficit leaves the economy and banking system vulnerable.
  - Egypt: successful stabilization and structural reform improved economic performance, but lower oil prices and weaker tourism and remittances have weakened near-term prospects.
  - Jordan: robust output growth, further declines in inflation, and a narrowing current account deficit following successful reform implementation.
- Africa:
  - Estimated growth in 1997 revised down to 3!/4percent from 3#/4percent projected in October 1997.
  - Weak outcome due to adverse weather, declines in commodity prices, and some armed conflicts.
  - Kenya: growth weakened partly from financial market pressures related to political uncertainties.
  - South Africa: growth slowed to 1#/4percent in 1997 from 3!/4percent in 1996.
  - Nigeria: growth close to 5 percent in 1997 but affected by power and fuel shortages and an unfavorable investment climate; sharp slowdown projected for 1998.
  - Algeria: growth slowed significantly in 1997 owing to drought and delays in industrial recovery.
  - Projected outlook: many African countries expected to grow in the neighborhood of 5 percent in 1998 and continue around that trend over the medium term, conditional on strong adjustment and reform policies and strengthened governance; weak commodity prices could cause growth to fall short of expectations.
  - Inflation remains under control in most of the region, including CFA franc zone countries.
  - HIPC Initiative assistance: Uganda expected to receive assistance this year; commitments made for Burkina Faso, Côte d’Ivoire, and Mozambique in 2000, 1999, and 2001, respectively; preliminary discussions on assistance to Guinea Bissau and Mali have taken place.

### Countries in Transition
- Overview and recent performance:
  - Spillovers from the Asian crisis affected financial and foreign exchange markets in a number of transition countries; short-term growth projections have been revised down in several cases.
  - Nonetheless, in 1997 both Russia and the transition countries as a group experienced positive growth for the first time in eight years.
  - In 1998, for the first time since transition began, none of the transition countries is expected to experience a decline in activity; the overall expansion is expected to strengthen further in the medium term.
  - Significant differences remain among countries in progress with stabilization and reform.
- Countries with prominent spillovers and policy needs:
  - Russia:
    - The ruble came under attack in late October and November and again in late January; authorities defended the exchange rate by sharply raising interest rates, accompanied by steep stock market declines.
    - Pressures reflected a persistently weak fiscal position with poor revenue collection and concerns about the evolution of the external position if fiscal imbalance is not addressed, as well as financial sector weaknesses.
    - Required action: fully and speedily implement the fiscal action plan adopted late last year, including the tax code.
  - Ukraine:
    - Progress toward single-digit inflation and positive growth in 1997 was undermined by inadequate fiscal adjustment, increased reliance on official short-term foreign borrowing, and heightened vulnerability when the Asian crisis intensified.
    - Authorities tightened monetary conditions sharply in response to exchange market pressures.
    - Early strengthening of public finances is essential to resolve financing difficulties sustainably.
    - Structural banking weaknesses have increased vulnerability to market sentiment shifts.
  - Estonia:
    - Domestic financial market pressures tied to a burgeoning current account deficit (13percent of GDP in 1997) and steep equity price rises were exacerbated by contagion from Asia.
    - Interest rates rose substantially in October and November; the stock market dropped sharply.
    - Since late last year markets have stabilized and interest rates have fallen somewhat as authorities reinforced bank prudential standards and tightened fiscal policies.
  - Belarus:
    - Lack of progress with structural reform, combined with unsustainable policies to boost output through rapid credit expansion and associated external arrears, led to a currency crisis in March 1998 and increased the risk that projected growth will not materialize.
- Transition countries showing resilience:
  - Czech Republic, Hungary, Poland:
    - Some have experienced upward pressure on currencies, suggesting reallocation of capital flows among emerging markets.
    - Their relative resilience is attributed largely to prior efforts to correct macroeconomic imbalances.
    - Czech Republic: following a currency crisis in May last year, tightened fiscal and monetary policy led to a significant narrowing of the current account deficit; maintaining improvement will require containing wage increases, avoiding budget slippages, and strengthening the banking system.
    - Hungary: little exchange market pressure from Asia; improved fiscal, growth, and trade performance after strong adjustment measures in 1995–97. Reduction of inflation (still 18 percent in 1997) remains a significant challenge.
    - Poland: recent financial market developments reflected confidence in macroeconomic policies; sustaining expectations requires firm fiscal policy and continued tight monetary policy to lower inflation.
- Role of structural reforms:
  - Structural deficiencies often underlie macroeconomic imbalances and financial market pressures.
  - Examples of needed reforms across transition countries:
    - Strengthen bank regulation and supervision.
    - Further privatization and enterprise reform.
    - Minimize monopoly power, including in public utilities.
    - Legal and institutional reforms to strengthen property rights and contract enforcement.
    - Improve tax systems and governance.
    - Pension and health care reforms to lessen fiscal pressures as populations age.
  - Empirical analysis indicates slower pace of market-oriented structural reform largely explains why growth in Russia and the other 11 countries of the former Soviet Union (excluding the Baltic countries) lags behind most central and eastern European countries.

### Appendix: Countdown to EMU — Progress Toward Convergence and Challenges Remaining
- EMU decision timetable:
  - On May 2, 1998, the Council of the European Union will decide which countries are qualified to participate in EMU.
  - Of the 15 EU member states, four are not planning to participate at the outset: Denmark, Sweden, and the United Kingdom have indicated they do not wish to participate at this point; Greece is aiming to join by 2001.
- Convergence criteria and assessments:
  - Eligibility assessment considers performance on inflation, public finances, interest rates, and exchange rates as specified in the Maastricht Treaty.
  - The European Commission and the European Monetary Institute published reports on March 25 assessing compliance; the Commission recommended that the 11 countries planning to participate in EMU in 1999 be judged to have qualified.
  - Except in Greece, inflation in EU countries was below the Maastricht reference value in 1997; general government deficits satisfied the 3 percent of GDP reference value.
  - Long-term interest rates for these countries satisfied the Maastricht reference value in 1997; no major tensions within the ERM since spring 1995.
- Prospects and interpretation issues:
  - The Council will also consider prospects for inflation and public finances, and whether gross government debt is falling at a satisfactory pace where it exceeds the Maastricht reference value of 60 percent of GDP.
  - Inflation projected to rise by 2 percent a year in 1998–99 in the EU as a whole; price stability is given priority in the ECB statute.
  - From 1998, fiscal deficits are expected to be below 3 percent of GDP in all countries, including Greece, projected to satisfy the deficit criterion for the first time this year.
  - Special attention on countries with debt ratios of the order of 100 percent or higher even if falling.
  - With long-term interest rates now differing by !/4 of 1 percentage point or less among countries aspiring to join EMU in 1999, markets expect the Commission’s recommendation to be endorsed by the Council.
- Role of the Stability and Growth Pact (SGP):
  - Countries need fiscal policies that promise compliance with the Maastricht Treaty in periods of cyclical weakness, as agreed in the SGP.
  - This ensures a balanced policy mix for the euro area and that countries retain leeway to deal with circumstances that might push their cycles out of phase with the euro area.
  - Appropriate targets for fiscal positions depend on need for room for discretionary fiscal measures, sensitivity to interest rate changes, and longer-term preparation for demographic fiscal impacts.
- Short-term assessment for 1998–99:
  - Despite declining interest spending and a helpful cyclical recovery, countries that need to reduce structural deficits are generally not projected to make progress on this in 1998–99.
  - Scope remains for further convergence of short-term interest rates in 1998.

*Source: _0598ch1pdf - Chapter III).*

### Box 3 of the October 1997 World Economic Outlook (pp. 58–69)

### Box 3 of the October 1997 World Economic Outlook (pp. 58–69)

### Scope and context
- The SGP also applies to EU countries outside the euro area, although without the threat of financial sanctions.
- Since the signing of the Maastricht Treaty, considerable progress has been made by the countries of the European Union in reducing inflation and fiscal imbalances.
- In 1997, general government budget deficits satisfied the 3 percent Maastricht Treaty reference value in all countries except Greece.
- The current projection shows no decline in the structural deficit for the prospective euro area in 1998–99.

### Macroeconomic outlook and policy interactions
- Increased flexibility in labor markets is critical for a stable and successful euro-area economy.
- The broad consensus in favor of policies directed at price stability could be challenged if sufficient progress is not made in reducing structural unemployment; without such support, even an independent central bank could find it difficult to sustain such policies for long.
- Given the short-term demands of the Maastricht criteria, governments have focused on macroeconomic rather than structural policies; from a broader perspective, policies in these two areas need to be mutually reinforcing.
  - A decline in unemployment can facilitate fiscal consolidation.
  - The durability of fiscal consolidation in the face of persistent high unemployment will inevitably be open to question.
  - A satisfactory fiscal position is a prerequisite for the tax cuts needed in most EU member countries to strengthen incentives to work and invest.

### Fiscal policy findings and projections
- The significant contribution that falling interest spending is expected to make to fiscal consolidation should allow authorities to devote considerable attention to issues of structural reform.
- Fiscal consolidation will generally need to focus on spending.
- The absence of projected improvement in the structural deficit for 1998–99 in the prospective euro area raises doubts about the will of countries to push fiscal consolidation further.

### Structural reform priorities and recommendations
- Measures to tackle unemployment should be broadly based, emphasizing:
  - deregulation,
  - reform of social benefits,
  - tax reduction.
- Most EU countries, the major continental countries in particular, have been reluctant or unable to implement the broad labor market reforms that are needed.
- Continued integration of national markets in the EU is likely over time to increase pressure for tax cuts in those countries with relatively high tax rates.

*Source: Box 3 of the October 1997 World Economic Outlook (pp. 58–69).*

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