## _082611a ## Source details **Canonical URL:** [_082611a](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_082611a.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_082611a.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_082611a.pdf.json) --- ### Main Findings — Exchange Rate and External Stability Assessments - Focus: country authorities express dissatisfaction with current treatment of external stability and exchange rate issues; complaints about both excessive and insufficient focus on exchange rates. - Value added: authorities indicate exchange rate assessments provide less insight than other areas of IMF surveillance. - Consistency: most Article IV reports contain an assessment of exchange rates and since 2008 have more consistently used standard methods. - Process: Mission Chiefs expressed dissatisfaction with accuracy and applicability of methods. - Evenhandedness: tension between consistency and accounting for country characteristics; deviations from standard methods are not always explicit. - Global perspective: access to results of the multilateral CGER exercise is restricted, limiting their use in multilateral surveillance. ### Key Recommendations — Exchange Rate and External Stability - Renew attention to global imbalances. - Ensure external stability assessments examine risks from capital and financial accounts (e.g., external balance sheets, capital flows, and reserve adequacy) in addition to current account and real exchange rate assessments. - Better integrate external stability assessments and overall policy recommendations; support via legal framework changes for surveillance. - Increase transparency of exchange rate assessments. Bilateral assessments: - Increase presumption that staff will: (i) explain adjustments to standard methods, (ii) relate differences in bottom line assessments to economic fundamentals, (iii) compare estimates across time. - Endorse best practice adjustments to CGER methods (particularly for non-CGER members). - Establish a central repository to improve consistency of policy advice and facilitate cross-country comparisons. Multilateral assessments: - Regularly publish an analysis of external balances, including results of the multilateral CGER exercise; seek to include more countries in the CGER exercise. - Reinforce consistency between multilateral and bilateral assessments by integrating country-specific adjustments, as warranted, into the multilateral CGER exercise. ### The CGER Methods — Evolution, Coverage, and Use - Evolution and adjustments: - CGER methods evolved since 2008 to address technical issues, crisis impacts (e.g., unsustainable fiscal deficits), and country-specific issues (e.g., oil exports, remittances). - Research Department standardized and disseminated CGER methods to mission teams. - Definition: “CGER” can mean (i) the multilateral CGER exercise or (ii) the standard CGER methods used in both multilateral and bilateral assessments. - Goal of an external stability assessment: - Provide clear analysis of (i) a member‘s current account and exchange rate level, and (ii) risks from the capital and financial accounts. - Methods to analyze exchange rate level: - CGER methods: Macroeconomic Balance (MB) approach, Equilibrium Real Exchange Rate (ERER) approach, External Sustainability (ES) approach. - Adjusted CGER methods: staff may adjust methods for technical issues and country circumstances (e.g., substitutes when specific data unavailable; oil-related considerations; remittances and aid flows for low income countries). - Alternatives: REER evolution, PPP, unit labor cost based REERs, export market shares, “structural competitiveness” measures. ### Multilateral CGER Exercise — Coverage, Uses, Transparency, and Planned Enhancements - Coverage and frequency: - Exercise covers 55 economies using methods developed by the Consultative Group on Exchange Rates. - Provides multilaterally consistent exchange rate assessments for members representing 90 percent of global GDP. - Conducted twice a year. - Uses and integration: - Inputs into IMF Early Warning Exercise (EWE), Vulnerability Exercises for Advanced and Emerging Markets (VEA and VEE), the G-20 Mutual Assessment Process (G-20 MAP), and the World Economic Outlook (WEO). - Incorporated into G-20 indicators for identifying persistently large current account imbalances. - Access and transparency: - Detailed results strictly confidential and not circulated to most Fund staff or other stakeholders; some country-specific results disseminated piecemeal in Article IV reports. - Recommendation: - Increase transparency by publishing and/or providing wider distribution of multilateral CGER results, with caveats (fully disclose methods and discuss precision). - Planned enhancements: - Emphasize analysis/assessment of current account balances and sustainability. - Give attention to policy and cyclical factors beyond structural comparisons. - Produce a self-contained report clarifying derivation/interpretation of CGER estimates and be more forthcoming about uncertainties. - Extension: - Exercise could be extended beyond current 55 economies over time to include other countries with sufficiently good data. ### Bilateral Exchange Rate Analysis — Implementation and Consistency - Coverage: bilateral exchange rate analysis undertaken for all Fund members. - 2010 Article IV reporting for 27 currencies: - Multilateral CGER estimates reported directly in 15 Article IV reports. - In another 7, country teams updated estimates using more recent exchange rate data and forecasts. - In 3 cases, teams made adjustments to CGER methods for country-specific circumstances. - In 1 case, no exchange rate estimates were included. - In 1 case, there was no 2010 Article IV consultation. - Best practice: where team estimates differ from multilateral CGER, Article IV reports should present both results and explain reasons for differences. - Challenges for non-CGER countries: - Insufficient or poor-quality data, short time series, different definitions, difficulty estimating trade elasticities, inappropriate assumptions in standard models. - Results should be presented modestly, with methods, assumptions, and robustness checks—especially for low income countries. ### Article IV Review and Survey Results — Perceptions and Usage - Overall improvement: review of 50 Article IV reports found near universal coverage of exchange rate issues, more comprehensive use of CGER methods, and more robust analysis compared with 2008. - Mission Chiefs’ views: - More than half saw applicability of CGER methods, consistency of CGER results, and data limitations as hampering exchange rate assessments “to some extent.” - Applicability and consistency presented little problem in advanced markets; more problematic for emerging market and low income countries; applicability a particular problem for members in Africa and the Middle East. - Only a quarter saw publication as a problem; preserving relations with authorities a problem in about a quarter of cases. - Stakeholder survey perceptions: - Country authorities ranked exchange rate analysis lower than most other surveillance areas; overall, out of eleven areas, exchange rate levels and competitiveness and exchange rate regime and policy ranked 7th and 8th respectively. - Perception statistics cited (percent of respondents saying area contributed to understanding or insight): 62%, 49%, 42%, 40%, 40%, 38%, 27%, 24%, 21%, 6%, 3%. - Techniques utilized (comparison 2008 vs 2011 TSR): one panel reports 52%, 40%, 8% for unspecified categories. - Financial market participants rated Fund analysis of exchange rate issues highly: more than 40% said Fund analysis is better than other sources (down from 52% in 2008 TSR). - For external stability/vulnerabilities, more than 80% of financial market participants said Fund analysis is better than other sources (up from 65% in 2008 TSR). ### Consistency, Adjustments, and Transparency — Findings and Recommendations - Findings from 2010 review: - Bottom line assessments were broadly consistent with quantitative estimates in most but not all cases. - A few cases showed bottom line assessments inconsistent with quantitative estimates with no justification. - Adjustments to CGER methods: - Review of 50 Article IV reports found 24 reports had adjustments to CGER methods; of these 24, 20 were judged by staff to provide adequate justification. - Case study (Bulgaria and Baltic Republics) showed differences arising from: - Exclusion of ERER for Bulgaria due to short sample and limited REER variation. - Different application of CGER methods across teams: different estimates of underlying current account balances; different pooled estimation techniques; variable transparency and robustness testing. - Recommended steps to improve consistency while preserving country specificity: - Transparently present any adjustments in the multilateral CGER exercise. - Research Department, with area departments, should endorse best practice adjustments to CGER methods for bilateral assessments. - Establish a central repository of endorsed exchange rate analyses to disseminate methods and best practice examples. Transparency recommendations for staff reports (routine explanations): - What changes in economic fundamentals drive changes in exchange rate assessments. - What adjustments have been made to standard assessment methods. - Why estimates have changed over time. - Explain differences from comparator countries in similar circumstances where relevant. Publication record (2010): - 95 of 135 Article IV staff reports were published with both (i) bottom line assessments and (ii) quantitative exchange rate estimates. - 20 reports included a bottom line assessment but no quantitative estimates. - 6 reports included neither a bottom line assessment nor quantitative estimate. - Of the remaining 14 reports: - 10 countries decided not to publish their reports. - 4 requested deletion of exchange rate estimates on market sensitivity grounds; among these 4: two had stabilized arrangements, one a peg, and one a floating exchange rate. ### External Stability — Integration with Policy Advice and Gaps - Many staff reports still focus primarily on exchange rate levels and insufficiently on capital and financial account risks. - Capital and financial account risks to assess include: - size and composition of capital flows and external assets, - access to international capital markets, - reserve adequacy. - Use of CGER methods increased from 30–40 percent of reports in 2007 to 70–80 percent in 2010, but discussion of other sources/indicators of external vulnerability was less frequent. - Views: - Country authorities saw little improvement in analysis of capital flows. - Nearly two-fifths of Executive Directors felt a significant share of staff reports had insufficient coverage of capital flows and reserve adequacy, driven primarily by authorities in advanced countries. ### Uncertainties and Technical Limits (Appendix I) - Forecast standard errors (Research Department estimates in multilateral CGER): - Forecast standard error for the current account norm in the MB approach is 2–3½ percentage points of GDP. - Forecast standard error for the equilibrium REER is about 10 percent. - Standard errors for non-CGER countries likely larger, implying greater uncertainty and requiring larger estimated deviations before concluding over- or undervaluation. - Technical challenges for non-CGER countries include data gaps, definition inconsistencies, use of standard coefficients, omitted variables, and judgment in application. ### Adjustments in Response to the 2008 Crisis (Appendix II A) - Three key multilateral CGER adjustments since spring 2010: - Fiscal balances: MB current account norms based on sustainable medium-term fiscal balances that stabilize public debt to GDP at 60 percent (80 percent for Japan). - Consumption ratios: use potential GDP as denominator for government consumption to GDP ratios to avoid output-gap distortions. - NFA targets: for countries with high external liabilities, current account norms can aim to reduce net external liabilities as a share of GDP to sustainable levels rather than rely on historical NFA to GDP ratios. - Note: no method currently exists to ensure these multilateral exercise adjustments are implemented in bilateral assessments. ### Country-Specific Modifications (Appendix II B) - Oil exporters: adjustments for exhaustible-resource intergenerational equity and front-loading considerations. - Workers’ remittances: treated like exhaustible resources; intertemporal considerations imply stronger current account balances for temporary remittance flows. - FDI flows and foreign aid: treated based on stability, composition, and accounting treatment; implications for ES approach and current account interpretation. ### Financial Sector Surveillance — Key Findings and Recommendations - Main findings: - Stakeholders have seen improvement in financial/macro-financial surveillance over past three years but scope exists to strengthen cross-border linkages coverage and early detection of country-level vulnerabilities. - Greater specificity and follow-up on policy recommendations needed. - FSAPs are useful when recent, but infrequent and not systematically incorporated into Article IVs. - Data limitations and insufficient support impede strengthened financial sector surveillance in Article IV consultations. - Recommendations (summarized): - Adopt a more risk-based approach and enhance understanding of interconnections; act as a global systemic risk advisor with a strategic plan. - Bridge financial stability assessments and surveillance work; consider more frequent FSAP-like stability assessments in Article IVs for systemically important countries. - Systematize a risk-based approach in Article IVs via a standardized analytical toolkit; disseminate vetted tools used in VEs and EWE. - Use Financial Surveillance Group and “colleges” of mission chiefs/MCM experts to support cross-pollination and consistency. - Eliminate data gaps: Article IVs should cover data issues pertinent to financial stability and bring forward review of data provision for surveillance to 2012. - Leverage work of other bodies (e.g., FSB). Boxed progress and resource figures: - Resources devoted to financial sector surveillance: estimated increase from $21.5 million in FY 2007 to $22.6 million in FY2010 and to $25.5 million in 2011; 14 percent of total surveillance spending in FY 2011. - Staffing and training: in 2010 the Fund hired 39 staff with financial sector experience or debt policy skills. - MCM time allocation: time devoted by MCM to Article IV fell by 15% between 2009 and 2010 from 42,000 hours to 36,000 hours; time devoted to FSAPs increased by 13% from 49,000 hours to 56,000 hours. - Note: structural break in budget/time-reporting between FY2010 and FY2011 may distort comparisons; alternative figures indicate spending of $26mn in FY 2011 and hours in FY2011 on FSAP were 80,000 and on Article IV 34,000. ### Financial Surveillance Institutional Proposals - Introduce a Financial Surveillance Group—an interdepartmental forum for sharing information, experiences, and best practice; strengthen analytical framework for transmission mechanisms and implement balance-sheet based tools. - Role for the Fund as global systemic risk advisor: - Adopt clear strategic agenda endorsed by Board/IMFC. - Process to identify emerging risks (e.g., “colleges” of mission chiefs/financial experts). - Establish external risk committee of senior officials and Fund management. - Suggested organizational options to integrate financial stability into Article IVs: - Ensure regular participation of a financial sector expert in systemic cases. - Mainstream financial stability analysis by developing capacity among non-specialist staff; mandatory financial sector training for new staff suggested. - Reconfigure resources to build Area Department financial analysis capability while retaining specialist MCM resources for complex cases. - More radical option: attach all bilateral surveillance resources to Area Departments with MCM refocusing on global systemic advisory role. ### Tools, Data, and Cross-border Analysis - Analytical toolkit expanded (FSIs, market indicators, stress testing, balance-sheet approaches, contagion models, GPM/GIMF scenario analysis) but uptake has been slow; mission chiefs most commonly use FSI tables. - Cross-border linkage analysis and network approaches used in specific Article IV reports (Bahrain 2010, Netherlands 2009, Luxembourg 2011) and policy work; improvements underway for SIBs/SIFIs monitoring. - Data priorities and progress: - Priorities: quarterly external debt by remaining maturity; general government debt data; more frequent CPIS data; detailed IIP data; real estate prices; quarterly sector balance sheets; cross-border exposures. - Progress: CPIS semi-annual; Coordinated Direct Investment Survey results; proposals to enhance BIS International Banking Statistics; G-SIFI data templates under FSB consideration. - Global funds industry assets: about $25½ trillion at end-June 2010 (down from $29¼ trillion at end 2007). ### FSAP Frequency and Resource Implications - Mandatory FSAPs for 25 systemically important financial sectors every five years likely insufficient to spot emerging risks in time. - Increasing FSAP frequency from five to three years for these economies would entail resource costs of around $2.8 million a year. - Lighter alternatives: focused routine assessments within Article IVs; continuous participation of a financial sector expert in country teams for members with systemically important financial sectors. ### Integration and Follow-up on Policy Recommendations - Findings: - Only around half of reports in FSS study included sufficient rationale for financial sector policy recommendations. - Where a recent FSAP or Fund program existed, recommendations were more specific. - FSAP case study: out of 6 cases, in three coverage of recommendations dropped off in the year following the FSAP. - Options: - Increase frequency of stability assessments. - Have missions focused on one aspect of stability. - Rebalance resources between FSAPs and Article IVs. - Risk Assessment Matrix (RAM) recommended for Article IVs to track risks and ensure follow-up. ### LICs — Vulnerabilities, Surveillance Adaptation, and Recommendations - LIC vulnerabilities: - Increased openness and sensitivity to commodity price movements; international food and fuel shocks severely affect the poor and often trigger fiscal interventions. - External grants amount to 4–5 percent of GDP, about one sixth of total revenue. - Dependence on volatile aid flows and remittances; weak coping mechanisms (ineffective automatic stabilizers, credit constraints, limited access to international markets). - Adapting tools: - Standard surveillance tools should be adapted to LIC structural differences, institutions, and data/capacity constraints. - VE-LIC framework created to monitor vulnerability indicators in LICs and assess spillovers; dry run presented April 2011 with a full run planned ahead of 2011 Bank/Fund Annual meetings. - Exchange rate issues in LICs: - No quality differences found between LICs and higher-income countries in assessing exchange rate policy/level, but greater use of country-specific adjustments in LICs. - Application of CGER methodologies yields less robust results in LICs; structural breaks and short time series complicate estimation. - More than 60 percent of LIC staff reports under review made adjustments to standard CGER methods. - Recommendations for LIC exchange rate assessments: - Develop broad guidelines on adjusting CGER methods for country groups (e.g., non-renewable resource exporters, large aid/remittance recipients). - Staff reports should be candid about CGER limitations and cautious in identifying misalignments due to higher margins of uncertainty. - Use comprehensive evaluations that combine CGER-type analysis with basic external sector indicators. - Financial sector surveillance in LICs: - Data weaknesses, capacity constraints, weak institutions, and legal/governance issues complicate assessment. - Need LIC-specific guidance on resolving troubled banks and red-flag lists drawn from past LIC bank/NBFI failures. - VE-LIC could help monitor spillovers and scenario analysis for LICs. ### Stimulus and Exit Policy Advice — Main Findings and Lessons - Scope: study covers January 2008 to April 2011. - Main findings: - Fund advice at onset of crisis was bold on stimulus and seen as timely; multilateral messages were clear and adapted to country circumstances. - At G-20 leaders‘ summit in November 2008 the MD called for coordinated global fiscal stimulus equivalent to 2 percent of GDP. - Bilateral advice on fiscal/monetary policy generally clear, substantiated, detailed, and medium-term. - In countries where policy loosening was implemented, staff reports elaborated on exit strategies in most cases (70 percent). - Perceptions: - Timeliness ratings: country authorities and EDs rated timeliness as 3.7 (scale 1–5). - Ratings that advice took into account changing conditions: 3.9 for country authorities and 3.8 for EDs. - Country authorities rated discussion of fiscal developments and policy as contributing to understanding: 62 percent; monetary policy: 38 percent. - Financial sector contingent liabilities (April 2011 Fiscal Monitor cumulative net deficit since crisis, country-by-country): - Ireland: 29 percent of (2010) GDP - Spain: 2.0 percent - U.K.: 6.0 percent - U.S.: 3.4 percent - Box 4 comparison (U.K. vs U.S. exit): - U.K.: staff supported frontloaded consolidation quantified as a structural adjustment of about 8.0 percentage points of GDP over a 5-year horizon; safeguards included automatic stabilizers and temporary targeted tax cuts if severe downturns. - U.S.: staff recommended maintaining stimulus in 2010 and starting fiscal adjustment in FY2012 with a total recommended reduction of 7½ percentage points of GDP over five years (about 1½ percentage points per year). *Italic: Source: IMF staff report content from _082611a (PDF chapter/section). * ### Chapter I. Exchange Rate and External Stability Assessments .................................................7 ### Chapter I. Exchange Rate and External Stability Assessments ### Main Findings - Focus: Country authorities express dissatisfaction with the current treatment of external stability and exchange rate issues. While the development of parallel (G-20) processes suggests an unmet demand to address global imbalances, there are complaints both about an excessive, as well as an insufficient, focus on exchange rates. - Value added: While views are not uniform, country authorities overall indicate that exchange rate assessments provide less insight than other areas of IMF surveillance. - Consistency: Most Article IV reports contain an assessment of exchange rates and since 2008 have more consistently used standard methods. - Process: Similar to the 2008 TSR, Mission Chiefs expressed dissatisfaction with the accuracy and applicability of methods. - Evenhandedness: There is a tension between ensuring consistency and accounting for country characteristics. Deviations from standard methods are not always explicit and different approaches by different country teams may result in inconsistencies. - Global perspective: Access to the results of the multilateral CGER exercise is restricted, limiting their use in multilateral surveillance. ### Key Recommendations - Renew attention to global imbalances. - Ensure that external stability assessments include an examination of risks from the capital and financial accounts (e.g. external balance sheets, capital flows, and reserve adequacy) in addition to current account and real exchange rate assessments. - Better integrate external stability assessments and overall policy recommendations. Support these efforts through changes to the legal framework for surveillance. - Increase the transparency of exchange rate assessments. Bilateral Assessments: - Increase the presumption that staff will: (i) explain adjustments to standard methods, (ii) relate differences in bottom line assessments to economic fundamentals, (iii) compare estimates across time. - Endorse best practice adjustments to CGER methods (particularly for non-CGER members). Establish a central repository to improve the consistency of policy advice and facilitate cross-country comparisons. Multilateral Assessments: - Regularly publish an analysis of external balances, including the results of the multilateral CGER exercise. Seek to include more countries in the CGER exercise. - Reinforce consistency between multilateral and bilateral assessments by integrating country-specific adjustments, as warranted, into the multilateral CGER exercise. ### A. Previous Reviews and Implementation of the 2007 Decision - Purpose: The paper evaluates IMF exchange rate analysis since the 2008 TSR, focusing on methods evolution, quality of multilateral and bilateral analysis, evenhandedness, transparency, and coverage/integration of external stability assessments. - 2008 TSR findings: Exchange rate analysis had strengthened since 2006 with improved clarity and coverage, but concerns remained about (i) consistency across countries, (ii) soundness of assessment methods, (iii) candor of assessments, and (iv) integration of exchange rate assessments into broader external stability and macroeconomic policy assessments. - IEO 2011 evaluation: Found adequate attention to global imbalances pre-2008 but expressed concern about an excessive focus on exchange rate levels; noted insufficient clear warnings about risks in the financial system, vulnerabilities in advanced markets, and contagion to emerging markets and LICs. - Implementation challenges for the 2007 Decision: - The 2007 Decision required staff to use the term "fundamental misalignment" if: (i) the real effective exchange rate was not at a level that would generate an equilibrium current account and (ii) the misalignment was significant. - Lack of precision in assessment methods and concerns about cross-country consistency led to a "fear of labeling" that may have weakened candor in some cases. - Problems in implementing the Decision resulted in extensive delays in Article IV consultations with some members. - Revised operational guidance (June 2009) eliminated the requirement to use specific terms such as "fundamental misalignment," emphasized that assessments should examine whether exchange rate policies promote external stability and contain a clear bottom line, while recognizing uncertainties inherent in such analysis. Lessons are reflected in the revised Bilateral Surveillance Guidance Note. ### Box 1. Previous Findings and Recommendations Triennial Surveillance Review (2008): - Noticed improvement in clarity and coverage of exchange rate issues. Nearly all staff reports contained a clear assessment of the exchange rate level based, in most cases, on reasoned and transparent analysis including the use of basic indicators, PPP approaches, and econometric techniques. - Description of the de facto exchange regime was adequate and advice was generally well supported. - Complaints about the emphasis on exchange rate levels; Executive Directors were dissatisfied with policy advice and the quality of exchange rate assessment methods. Mission chiefs expressed frustration at the lack of guidance and analytical tools. - Called for better integration of exchange rate analysis with the overall macroeconomic assessment, greater transparency regarding the work underlying exchange rate assessments, and improved candor in some cases. Recommended continued improvements in assessment methods, consistent implementation of guidance, and more work to improve analysis in challenging cases. Recommended that the 2008–11 statement of surveillance priorities include exchange rate and external stability assessments. IEO Report on IMF Performance in the Run up to the Financial and Economic Crisis (2011): - Found that in its pre-2008 surveillance, the IMF appropriately focused on global external imbalances and the risk of an exchange rate crisis, but did not look at how imbalances were linked to systemic risks in financial systems. - Concluded that the 2007 Decision on Bilateral Surveillance led to a greater emphasis on exchange rate levels and currency misalignments. This resulted in less attention to external stability more broadly and in some cases triggered tensions between the IMF and country authorities. *Prepared by Lawrence Dwight, Nicolas Million, and Bert van Selm (all SPR), Irineu de Carvalho Filho (RES), and Jacques Miniane (EUR).* ### 5. The methods developed by the Consultative Group on Exchange Rates (CGER) ### 5. The methods developed by the Consultative Group on Exchange Rates (CGER) ### Evolution and adjustments of CGER methods - CGER methods have continued to evolve since 2008 to address technical issues (e.g., data sources), account for the impact of the global economic and financial crisis (e.g., unsustainable fiscal deficits), and address country-specific issues (e.g., oil exports and remittances). - The Research Department has standardized and disseminated CGER methods to mission teams that conduct assessments. - “CGER” can refer to either: (i) the multilateral CGER exercise or (ii) the standard CGER methods used in both multilateral and bilateral assessments; the text distinguishes these as “multilateral CGER exercise” and “CGER methods”. ### CGER methods, adjusted methods, and alternatives (Box 2) - Goal of an external stability assessment: - Provide a clear analysis of: (i) a member‘s current account and exchange rate level, and (ii) risks that could arise from the capital and financial accounts. - Methods to analyze the level of the exchange rate: - CGER methods: Macroeconomic Balance (MB) approach, Equilibrium Real Exchange Rate (ERER) approach, and External Sustainability (ES) approach. - Adjusted CGER methods: staff may adjust CGER methods to address technical issues and country circumstances (e.g., substitutes when specific data are unavailable; oil-related considerations for oil exporters; remittances and aid flows for low income countries). - Alternatives used by country teams: (i) the evolution of real effective exchange rates (REER), (ii) purchasing power parity (PPP), (iii) unit labor cost based REERs, (iv) export market shares, and (v) “structural competitiveness” measures (e.g. Doing Business Indicators). ### Implementation, dissemination, and capacity building (Box 3) - Training: - INS, RES, and SPR conduct an annual three-day joint course on exchange rate assessment in IMF surveillance, providing hands-on practice. - The Research Department produced a guidance note on applying CGER methods to non-CGER countries. - Websites and tools: - SPR and Research maintain internal websites with operational guidance, background materials, and datasets. - SPR has developed quantitative tools (including a panel data set and econometric programs) to implement standard CGER methods for 182 countries. - Area department working groups (African and Middle East and Central Asia Departments) produced region-specific coefficients and standardized results. - Staff research: - IMF Working Papers extend CGER methods for countries with remittances, oil exports, low incomes, or particular regions. - Multilateral approaches: - The Research Department conducts a semiannual multilateral CGER exercise. ### The multilateral CGER exercise (Section C) - Coverage and frequency: - The multilateral CGER exercise covers 55 economies—using methods developed by the Consultative Group on Exchange Rates. - The exercise provides multilaterally consistent exchange rate assessments for members representing 90 percent of global GDP. - It is conducted twice a year. - Uses and integration: - Inputs into the IMF‘s Early Warning Exercise (EWE), Vulnerability Exercises for Advanced and Emerging Markets (VEA and VEE), the G-20 Mutual Assessment Process (G-20 MAP), and the World Economic Outlook (WEO). - Estimates are incorporated into G-20 indicators for identifying persistently large current account imbalances. - Access and transparency: - Access to results is restricted; detailed results are strictly confidential and not circulated to most Fund staff or other stakeholders. - Some country-specific results are disseminated on a piecemeal basis, as part of Article IV reports. - Recommendation on publication: - The IMF should increase transparency by publishing and/or providing wider distribution of the multilateral CGER results, with caveats (fully disclose methods and discuss precision). - Publication would support greater accountability, candor, and evenhandedness. - Planned enhancements: - Research Department plans to revamp the exercise with three main goals: - Emphasize analysis and assessment of current account balances and current account sustainability (broader multidimensional view of external stability). - Go beyond structural comparisons to give attention to policy and cyclical factors (monetary policy, business cycle, global capital market factors). - Produce a new, self-contained report clarifying derivation and interpretation of CGER estimates and be more forthcoming about uncertainties. - Extension: - The multilateral CGER exercise could be extended over time beyond the current 55 economies to include other countries with sufficiently good data. ### Bilateral exchange rate analysis (Section D) - Coverage: - Bilateral exchange rate analysis is undertaken for all Fund members. - For multilateral CGER countries, mission teams may report multilateral CGER results and/or adjusted results reflecting country-specific circumstances. - For non-CGER countries, mission teams make their own estimates, generally incorporating CGER methods and making adjustments as needed. - Consistency gains from multilateral CGER: - For 2010, out of the 27 currencies covered: - Multilateral CGER estimates were reported directly in 15 Article IV reports. - In another seven, country teams updated estimates using more recent exchange rate data and economic forecasts (often using a template supplied by the Research Department). - In three cases, teams made adjustments to CGER methods for country-specific circumstances (examples: South Africa updated CGER estimates based on mission information; Switzerland adjusted the underlying current account balance due to accounting treatment of reinvested earnings and capital gains). - In one case, no exchange rate estimates were included in the report. - In the final case, there was no 2010 Article IV consultation. - Best practice: where team estimates differ from multilateral CGER, Article IV reports should present both results and briefly explain reasons for differences. - Challenges for non-CGER countries: - Insufficient or poor-quality data, short time series, different definitions for economic concepts, difficulty estimating trade elasticities, and inappropriate assumptions in standard models (Appendix I). - Consistent implementation across countries is difficult. - Results should be presented modestly, with clear statement of methods and assumptions, plus robustness checks—especially for low income countries. ### Article IV review and survey results (Section E) - Overall improvement: - A review of Article IV reports found near universal coverage of exchange rate issues, more comprehensive use of CGER methods, and more robust exchange rate analysis compared with 2008 (review covered 50 Article IV reports). - The vast majority of adjustments for country circumstances have sound economic justifications. - Mission chiefs’ views (Figure 2): - More than half saw the applicability of CGER methods, the consistency of CGER results, and data limitations as hampering exchange rate assessments “to some extent.” - Applicability and consistency presented little problem in advanced markets but some problems for emerging market and low income countries; applicability was a particular problem for members in Africa and the Middle East. - Data limitations and resource constraints were more relevant for low income than for advanced economies. - Only a quarter of mission chiefs saw publication as a problem (slightly less than in 2008). - Preserving relations with the authorities was seen as a problem in about a quarter of cases (up from one fifth in 2008). - Publication and preserving relations with authorities were seen as greater problems for emerging markets than for advanced and low income countries. - Stakeholder surveys (Figures 3–5): - Country authorities ranked exchange rate analysis lower than most other areas of surveillance. - Ratings were very low for authorities in advanced countries and Europe (possibly due to Euro Area common currency issues). - Country authorities in low income countries and Africa and the Middle East were relatively more positive; about half said analysis of exchange rate issues contributed to understanding or insight. - Overall, out of eleven areas, analysis of exchange rate levels and competitiveness and exchange rate regime and policy ranked 7th and 8th, respectively. - Perception statistics and indicators cited: - In one survey figure, items listed with percentages (percent of respondents saying area contributed to understanding or insight) include: - 62% - 49% - 42% - 40% - 40% - 38% - 27% - 24% - 21% - 6% - 3% - In another summary of techniques utilized for exchange rate assessment (comparison 2008 vs 2011 TSR), one panel reports 52%, 40%, 8% for unspecified categories. - Perceived improvement: - Country authorities on average saw “a little” improvement in exchange rate analysis, with low income countries and Africa and the Middle East more positive than Asia and Europe. - Executive Directors felt the quality of analysis met expectations “in only some cases”; perceived quality declined with increases in country income. - On average, Executive Directors saw “a little to some” improvement, lower than other areas surveyed. - Financial market participants rated Fund analysis of exchange rate issues very highly: more than 40% said Fund analysis is better than other sources (down from 52% in the 2008 TSR). - For analysis of external stability/vulnerabilities, more than 80% of financial market participants said Fund analysis is better than other sources (up from 65% in the 2008 TSR). *Source: IMF staff report section “5. The methods developed by the Consultative Group on Exchange Rates (CGER)”* ### 18. Differences in perception likely reflect a number of factors. Evidence was ### _082611a - 18. Differences in perception likely reflect a number of factors. Evidence was ### Perceptions from Interviews and Surveys - Interviews with country authorities: - Some authorities argued that Fund advice was "too generic" and "was not sufficiently focused on policy implementation." - Some expressed dissatisfaction with the initial implementation of the 2007 Decision, noting it "put too much focus on exchange rates at the expense of the broader range of issues relevant to external stability." - Views on multilateral surveillance split: some felt IMF focus on exchange rate misalignments distracted from global financial system risks; others urged continued pressure and public comment on exchange rate spillovers in both bilateral and multilateral surveillance. - Survey comments: - Nine comments on exchange rate analysis were received from country authorities and Executive Directors. - Comments stated assessments did not sufficiently: - 1) account for country circumstances (e.g. membership in a monetary union or the features of a small open economy); - 2) address broader stability issues (e.g. reserve accumulation, reserve adequacy, capital flows, reducing imbalances); - 3) promote evenhandedness (by standardizing assessments and taking a harder line with large members). ### Candor and Evenhandedness - Executive Directors recognized tensions between consistency of exchange rate assessments and flexibility to address country-specific factors. - In the 2007 Decision, Directors called for "... evenhandedness across members, affording similar treatment to members in similar relevant circumstances...." and stated the Fund’s "assessment of a member‘s policies and its advice on these policies will pay due regard to the circumstances of the member." - In the 2008 TSR Executive Directors stressed the need for "greater consistency across countries in terms of the choice of methods and the presentation of the results..." ### Consistency across Countries — Findings from 2010 Review - Staff analysis of bilateral exchange rate assessments in all 2010 Article IV reports found bottom line assessments were broadly consistent with quantitative estimates in most but not all cases. - Examples: most countries assessed as "overvalued" had estimated exchange rate ranges above zero; "in equilibrium" had ranges close to zero; "undervalued" had ranges below zero. - The degree or number of countries assessed as over or undervalued did not significantly differ by exchange rate regime. - In a few cases, bottom line assessments were inconsistent with quantitative estimates and staff provided no justification: - Two countries at either end of the equilibrium category in Figure 7 had bilateral estimates pointing to a 2–28 percent overvaluation in the first case and a 15–23 percent undervaluation in the second, yet staff judged the exchange rate "broadly in line with fundamentals" without explanation. - Adjustments to CGER methods: - Review of 50 Article IV reports found 24 reports had adjustments to CGER methods. - Of these 24, 20 were judged by staff to provide adequate justification. - This highlights tension between staff judgment and the need for consistency/evenhandedness. ### Case Study: Bulgaria and the Baltic Republics (Box 4) — Sources of Differences - Two sources of differences: - Exclusion of one method for Bulgaria‘s 2010 Article IV report—the equilibrium real exchange rate approach (ERER)—due to a sample judged "too short" and limited real exchange rate variation; ERER used in Baltic cases and showed the largest overvaluation affecting overall results. - Different application of common CGER methods reflecting country team judgments: - Different estimates of underlying current account balances: - Bulgaria and Lithuania teams used the medium term WEO forecast. - Estonia and Latvia teams used the latest current account balance adjusted for cyclical position and past changes in exchange rates. - Different techniques to estimate current account norms: - Estonia and Bulgaria used the hybrid pooled estimation method. - Latvia and Lithuania used the pooled estimation method. - All teams performed robustness tests; in only one case did teams share alternative specifications with authorities and the Board. - Transparency varied: Estonia and Latvia reports provided estimates of the underlying current account and current account norm; Latvia also provided econometric details. - Breadth of discussion of external stability varied across staff reports; selected issues papers for Bulgaria and Lithuania conducted deeper analysis of productivity changes and capital flows. ### Recommended Steps to Improve Consistency While Preserving Country Specificity - Any adjustments in the multilateral CGER exercise should be transparently presented. - The Research Department, in collaboration with area departments, should endorse best practice adjustments to CGER methods in bilateral assessments to account for country circumstances and increase likelihood that countries in similar circumstances receive similar treatment. - The Fund should establish a central repository of endorsed exchange rate analyses to disseminate up-to-date assessment methods and best practice examples, allowing easier cross-country comparison, enhancing evenhandedness, and spreading new approaches. ### Time Dimension and Stability of Classifications - From 2008 to 2010, just over half of members had exchange rates classified as "in equilibrium" (Table 1); this did not change significantly over the period. - The percentage of countries classified as undervalued fell by half from 2008 to 2010, reflecting declines in current account surpluses after the economic crisis. - Individual country stability: - In 2010, most countries remained in the same category as in 2009. - A country rated overvalued in 2009 had a 62% chance of being rated overvalued in 2010. - Reasons for category changes: - Legitimate reason: evolution in real effective exchange rate. - Illegitimate reason: change of methodology without justification or explanation (Box 5). - Case studies of four countries (Algeria, Ireland, Laos, Singapore) showed mixed consistency: - Algeria: bottom-line "broadly in equilibrium" unchanged while adjusted CGER estimates suggested undervaluation of 10–34 percent in 2009 and 15–23 percent in 2010; staff changed ERER explanatory variable from oil prices to terms of trade without explaining the impact on estimates. - Ireland: assessments consistent with fundamentals but staff could have provided more detail on drivers of the current account norm change. - Laos: methods and assessments changed significantly over time with insufficient explanation. - Singapore: methods, estimates, and bottom-line assessments were consistent over time; drivers of results were reported. ### Transparency — Findings and Recommendations - Exchange analyses are mixed in transparency; many teams had economic reasons for adjustments but did not report them. - Bulgaria and Baltic staff reports did not explain reasons for adjustments or non-use of certain methods. - Many staff reports simply state CGER estimates, creating a "black box" perception. - Recommended routine explanations in staff reports: - 1) what changes in economic fundamentals drive changes in exchange rate assessments; - 2) what adjustments have been made to standard assessment methods; - 3) why estimates have changed over time. - Best practice would also explain differences from comparator countries in similar circumstances; this would be easier after establishing a repository. - Explanations could be brief (several sentences and/or tables) and are not meant to prevent staff from using judgment. ### Publication Record (2010) - In 2010: - 95 of 135 Article IV staff reports were published with both (i) bottom line assessments of the exchange rate level and (ii) quantitative exchange rate estimates. - 20 reports included a bottom line assessment but no quantitative estimates. - 6 reports included neither a bottom line assessment nor quantitative estimate. - Of the remaining 14 reports: - 10 countries decided not to publish their reports (in accordance with the Fund‘s transparency policy). - 4 requested deletion of exchange rate estimates on the basis of market sensitivity; of these 4, two countries had stabilized arrangements, one a peg, and one a floating exchange rate. ### External Stability and Integration with Policy Advice - Analysis of risks to external stability in many staff reports still focuses primarily on exchange rate levels and insufficiently on capital and financial account risks. - Even when the underlying current account is in equilibrium, the capital and financial account may be a source of instability due to: - balance sheet vulnerabilities, - spillovers, - financing constraints. - Coverage should go beyond current account and real exchange rate levels to assess risks from the capital and financial account, including: - size and composition of capital flows and external assets, - access to international capital markets, - reserve adequacy (Box 2 highlights indicators that should be considered). - Use of CGER methods increased from 30–40 percent of reports in 2007 to 70–80 percent in 2010, but other potential sources or indicators of external vulnerability were discussed less frequently. - Country authorities and Executive Directors views: - Country authorities saw little improvement in analysis of capital flows (Figure 9). - Nearly two-fifths of Executive Directors felt a significant share of staff reports had insufficient coverage of capital flows and reserve adequacy. - Dissatisfaction was driven primarily by authorities in advanced countries; authorities in emerging markets were less dissatisfied. *Source: _082611a - 18. Differences in perception likely reflect a number of factors. Evidence was (PDF chapter/section).* ### 30. Ironically, these results may partly reflect improved implementation of CGER ### _082611a - 30. Ironically, these results may partly reflect improved implementation of CGER ### Integration and implementation of CGER analyses in bilateral surveillance - Adjusted CGER analyses were time-intensive, diverted resources from other areas, and were complex to explain; in some cases they distracted from discussion of other policy issues with policymakers. - In sensitive cases, findings of exchange rate over- or undervaluation became a key focus of consultations, a concern echoed by country authorities—particularly those with fixed or heavily managed exchange rates. - Integration of external stability assessments with the overall policy discussion remains insufficient: - Assessments of risks to external stability should discuss contributing factors to vulnerabilities and trace the role of the overall policy mix (external and domestic policies) to inform overall policy recommendations. - Example: vulnerabilities from an over- or undervalued real exchange rate could be addressed via changes in the exchange rate, fiscal, monetary, or structural policies, or a combination. - Evidence on integration is mixed; Executive Directors are generally dissatisfied with integration quality. On average, staff reports met expectations for integration in only a few cases. - Proposal to improve integration: - Members could consider revising the 2007 Decision or Articles of Agreement to recognize that other policies, aside from exchange rate policies, can create external instability. - The 2007 Decision and Articles of Agreement are characterized as having an exchange rate bias and creating an artificial distinction between domestic and external policies, which is not conducive to integrating bilateral and multilateral surveillance or policy areas. ### Appendix I — Technical challenges for exchange rate analysis of non-CGER countries Challenges identified: - Data: - For some countries, particularly LICs, data required by CGER methods (productivity, terms of trade, net foreign assets, trade elasticities, sectoral value added and labor inputs, trade weights, trade restrictions, international investment position) are not available. - Structural breaks in data can affect estimate quality. - Definitions: - Variation across countries in definitions (e.g., fiscal deficits: central vs general government; productivity: tradable vs non-tradable or proxying with GDP per capita; trade weights including or excluding services) reduces consistency of exchange rate estimates. - Use of standard coefficients: - Short time series prevent country-specific trade elasticity estimation; standard elasticities are applied. - Coefficients for the current account norm in the macroeconomic balance (MB) approach rely on panel regressions. - Tradeoff: country-specific estimates vs standard pooled coefficients — pooled regressions improve efficiency but may introduce bias from heterogeneity. - Non-CGER countries are not included in the panel generating standard coefficients, implying potential error when applying standard coefficients to non-CGER countries. - Omitted variables: - CGER methods include some corrections (e.g., dummy for financial centers) but other plausibly significant variables for certain members remain unincorporated. - Consistency of adjustments across countries: - Country teams make country-specific adjustments; systematic, cross-departmental processes to reinforce consistency across similar countries do not yet exist. - Judgment in application: - CGER methods permit judgment (e.g., methods to calculate the underlying current account; choice of sustainable NFA targets when latest NFA positions contain large external liabilities). - CGER assumptions: - MB and ES approaches assume access to financing. In some LICs, external financing is scarce and imports are financed through remittances/grants; current account will be close to balance by definition despite development needs implying a deficit norm. Unadjusted application could mistakenly suggest undervaluation. - Multilateral consistency: - The multilateral CGER imposes multilateral feasibility by adding/subtracting an adjustment specific to each assessment method; bilateral assessments done individually may not apply the same adjustment, risking multilateral inconsistency. - Uncertainties (Research Department estimates): - In the multilateral CGER exercise the forecast standard error for the current account norm in the macroeconomic balance approach is 2–3½ percentage points of GDP. - The forecast standard error for the equilibrium REER is about 10 percent. - Standard errors for non-CGER countries are likely larger, implying greater uncertainty and requiring larger estimated deviations from equilibrium before concluding over- or undervaluation. - Readers unfamiliar with these considerations may impute more precision to exchange rate estimates than warranted. ### Appendix II — Developments in CGER methods A. Evolution in response to the 2008 financial crisis — three key adjustments in the multilateral CGER exercise: - Fiscal balances: - Since spring 2010, MB current account norms are based on sustainable medium-term fiscal balances defined as fiscal balances which, if maintained, would stabilize the public debt to GDP ratio at 60 percent (80 percent for Japan). - Consumption ratios: - To avoid output-gap-driven distortions, the multilateral CGER exercise uses potential GDP as the denominator for government consumption to GDP ratios. - Net Foreign Asset (NFA) targets: - For countries with high external liabilities, the multilateral CGER exercise has proposed using current account norms that reduce net external liabilities as a share of GDP to a sustainable level rather than rely on historical NFA to GDP ratios. Note: While these adjustments are made in the multilateral exercise, there is currently no method to ensure they are implemented in bilateral assessments. B. Other modifications to account for country-specific factors - Multilateral CGER: - Oil exports: adjusted to account for exhaustible-resource intergenerational equity (implying higher current account balance) and the possibility that capital-scarce, credit-constrained countries may optimally front-load oil revenues for public investment (implying lower current account balance). Africa, Research, and Strategy Departments are developing methods to estimate these implications. - Country assessments: - Workers’ remittances: behave like an exhaustible resource; intertemporal savings considerations would warrant a stronger current account balance for countries receiving large but temporary remittances. - FDI flows: as a more stable source of external financing with contingent liabilities and risk sharing, FDI can make current account deficits and net foreign liabilities more sustainable—relevant for ES approach NFA sustainability. - Foreign aid: depending on composition/duration, aid can resemble remittances or resource flows. Aid recorded "above the line" as grants should be offset by higher imports; aid as subsidized lending recorded "below the line" can raise current account deficits and could erroneously suggest overvaluation. ### CHAPTER II — Financial sector analysis in bilateral surveillance: Key findings and recommendations Key findings: - Stakeholders have seen an improvement in the Fund’s financial/macro-financial surveillance over the past three years. - The Fund’s contribution could be strengthened further, particularly on cross-border linkages, while ensuring country-level vulnerabilities are detected early and acted upon. - There is scope for greater specificity and follow-up on policy recommendations. - Country authorities and Mission Chiefs find financial stability assessments (FSAPs) useful when recent, but FSAPs are infrequent, not systematically incorporated into Article IV reports, and questions exist about guaranteeing financial stability analysis quality in bilateral surveillance. - Data limitations and insufficient support impede strengthened financial sector surveillance in Article IV consultations. Recommendations (summarized action points): - Adopt a more risk-based approach to surveillance and enhance understanding of interconnections: - Adopt the role of a global systemic risk advisor and set a strategic plan to address systemic real/financial risks; elaborate and disseminate a policy doctrine on key issues; ensure work on financial networks and systemically important financial institutions is disseminated/used in Article IV consultations. - Bridge better between financial stability assessments and surveillance work; consider more frequent FSAP-like stability assessments in Article IVs, especially for countries with systemically important financial sectors; increase area department capacity for financial stability analysis, including training. - Systematize a risk-based approach in Article IVs: standardize the analytical toolkit; make vetted tools (including those developed for the Vulnerabilities and Early Warning Exercises (EWE)) available to country teams; encourage authorities to share stress test results and share the Fund’s scenario analysis. - Help make connections: use the Financial Surveillance Group and “colleges” of mission chiefs/MCM experts for countries with strong financial linkages to support cross-pollination/consistency/cooperation across country teams. - Work to eliminate data gaps: Article IVs should cover data issues pertinent to financial stability, signaling gaps and weaknesses; bring the review of data provision for surveillance forward to 2012. - Leverage work of other bodies (e.g., the FSB, emerging risk boards) for the Fund’s surveillance. Box 1 — Progress over the past three years (selected precise figures and measures): - Resources devoted to financial sector surveillance: estimated increase from $21.5 million in FY 2007 to $22.6 million in FY2010 and to $25.5 million in 2011; 14 percent of total surveillance spending in FY 2011. - Staffing and training: - In 2010 the Fund hired 39 staff with financial sector experience or debt policy skills, doubling the number of hires with specialist skills in recent years. - Guidance and tools: - Improved guidance: Financial Sector Surveillance Guidance Note (FSSGN, 2009). - Analytical toolkit expanded and disseminated; MCM catalogued its tools on the intranet. - FSAPs and exercises: - FSAPs made more flexible (2009); mandatory FSAPs for economies with systemically important financial sectors (2010). - Modular FSAPs established in 2009 for focused updates. - Introduction of the twice-yearly Early Warning Exercise (EWE) and Vulnerability Exercise for Advanced economies (VEA) since 2009 to identify key risks including in the financial sector. *Source: IMF staff paper extracted from _082611a - 30. Ironically, these results may partly reflect improved implementation of CGER* ### introduction of a Financial Surveillance Group—an interdepartmental forum for sharing information, ### _082611a - introduction of a Financial Surveillance Group—an interdepartmental forum for sharing information, ### Purpose and recommended institutional changes - Introduce a Financial Surveillance Group—an interdepartmental forum for sharing information, experiences and best practice, and for helping to identify cross-cutting issues. - Recommended strengthening of: - the analytical framework for transmission mechanisms; and - greater implementation of balance-sheet based tools. - Status: In progress. - Recent attention areas highlighted: - Interconnectedness and systemic issues: a conceptual study—Understanding Financial Interconnectedness—demonstrated the importance of networks and analyzed the critical global financial nodes and inter-linked networks (with far greater reach); underscored need for surveillance to better grasp these linkages. - Regular monitoring of activities of systemically important financial institutions (bank and non bank) is underway. - Macroprudential work: Board paper—Macroprudential Policy: An Organizing Framework—offered preliminary views on diagnosing and tackling systemic financial risk, choice of instruments, and institutional design. - Filling Information Gaps: Progress on the G20 Data Gaps Initiative and STA developing a Special Data Dissemination System plus for systemically important economies for discussion in the Eighth Review of the Data Standards Initiative scheduled for early 2012. ### Role for the Fund on financial stability (Section II) - Strategic role: Fund’s financial stability role should span from detailed bilateral work to global strategy. - Rationale: External Consultants’ report on the IMF and Global Financial Stability and academic work (Truman and Schinasi (2010)) argue the Fund, with universal membership and macro-financial skills, should act as a global systemic risk advisor. - Focus areas for the Fund as a global systemic risk advisor: - macroeconomic and macro-financial stability; linkages between them; implications of macroeconomic policies for global financial system stability. - Continue bilateral-level attention and cross-border issues. - Complementarity of bilateral and global roles: - In-depth country knowledge needed to track domestic vulnerabilities and spot risks early. - Knowledge of financial interconnections necessary to inform country-level work. - Multilateral policy principles for systemic institutions, instruments, markets should be used consistently in bilateral surveillance. - Suggested steps to support global advisor role: - Adoption of a clear strategic agenda for the Fund for financial stability, endorsed by the Board/IMFC, to assess emerging vulnerabilities, prioritize potential risks, and set a work program. - Strengthened focus on risks to financial stability, including at bilateral level. - Process to identify emerging risks—e.g., through “colleges” of mission chiefs/financial sector experts for countries with extensive financial links (see Section V.C). - Progress on understanding transmission channels and filling data gaps. - Establish an external risk committee comprising senior officials from systemic institutions and Fund management to meet regularly to discuss macroeconomic or financial risks. ### State of financial sector surveillance: progress and remaining gaps (Section III) - Overall assessment: - Evidence of progress, but most stakeholders see scope for further improvement. - TSR—Health Check and Statistical Information surveys with Country Authorities (CAs), Financial Market Participants (FMPs), and Executive Directors (EDs) and interviews with CAs point to improvement over past three years. - Progress findings: - Quality of financial sector analysis and advice has improved at least to some extent compared to pre-crisis period. - Financial sector analysis and advice rated more favorably than other issues (such as exchange rate issues) by CAs and EDs. - Improvements noted more by Emerging Markets (EMs) and Low Income Countries (LICs) than by Advanced Economies (AEs). - Regional variation: progress on quality viewed less positively in Asia than elsewhere. - Contribution: - Financial sector surveillance ranked second (after fiscal policy) in contribution to CAs’ understanding of issues. - Roughly half of EM and LIC respondents thought Fund surveillance had contributed most to their understanding of: understanding of financial sector vulnerabilities, potential macroeconomic implications, and to a lesser extent regulatory and supervisory issues. - Fewer AEs viewed the Fund’s contribution positively. - Coverage and risk signaling: - Majority of CAs think discussion of risks appropriate for their own country but think risks are signaled too infrequently for other countries. - FMPs and EDs see scope for more discussion of tail risks and especially transmission channels. - Two-way macro-financial transmission channels: - Scope to improve coverage of both: (i) impact of financial sector (directly or through cross-border linkages) on domestic/external stability; and (ii) effect of macroeconomic developments on the financial sector. - CAs request greater attention to analyzing macro-financial linkages and advising on country-specific macroprudential policies. - Cross-border and finance-to-finance linkages: - Need more focus—financial linkages between institutions and across markets/borders were key propagation mechanisms in 2008 crisis. - FMPs rated IMF’s analysis of cross-border risk transmission as just above average but lower than other types of financial surveillance activities; second lowest out of six policy areas assessed. - Main challenge: lack of data for multi-country financial institutions (Mission Chief survey, see Box 2). ### Stakeholder observations and Mission Chiefs’ perspectives (Box 2 and Figure summaries) - Mission Chiefs’ quoted challenges on cross-border linkages: - Many issues pertain to cross-border financial institutions and policies and should be developed in a broader context than bilateral surveillance. - The situation in Europe is fluid and complex where most cross-border issues for some countries come from. - Lack of relevant data on cross-border exposures; poor quality of financial sector data; lack of data on cross-border financial flows. - Assessing cross-border risks is hard because of lack of information on operations of multi-country financial institutions. - FSAP integration: - CAs seek better integration of Financial Stability Assessment Programs (FSAP) into Article IV surveillance. - FSAP findings, particularly stability assessments, need proper incorporation into bilateral surveillance and follow-up on recommendations. - FSAPs viewed favorably in interviews; survey results mixed. - FSAPs viewed as helpful in sharpening bilateral surveillance by just over half of country authorities: 43 percent for AEs, 51 percent for EMs, 65 percent for LICs. - Calls for better integration of FSAP teams (and broader technical assistance providers) with area departments. - Mission Chiefs’ views on impediments and helpful supports (Figure 3 summary): - Main impediments: data limitations/lack of access to information and limited mission support from functional departments. - Most helpful in strengthening Article IV discussions: extra support from functional departments, recent FSAP or FSAP update, analytical tools (EWE, VEs, GFSR), Financial Sector Surveillance Guidance Note, cross-departmental surveillance discussions, WEO, GFSR, REOs, recent Article IV analysis on linkages. - Mission Chiefs see scope to do more macro-financial analysis, especially among EMs and LICs, and for more work on cross-border linkages and policy implications. ### Deepening analysis and greater global focus (Section IV) - Evidence from case studies and review of fifty Article IVs shows room to deepen and strengthen financial sector surveillance. - Main areas for strengthening: - Assess two-way risk transmission in more depth. - Analyze cross-border risks more closely. - Make policy recommendations more specific and follow them up more rigorously. - Case studies (Box 3): - FSS Case study: Breadth and Depth of Financial Sector Surveillance—17-country case study of Article IV reports for 2010 (Botswana, Brazil, Cameroon, Iceland, India, Kazakhstan, Korea, Lebanon, Pakistan, Peru, Philippines, Romania, Russia, Spain, Switzerland, United Kingdom, and the United States). Assessed breadth of coverage, analytical tools used, discussion of two-way transmission of risks, inclusion of tail risk and risk assessments, and specificity/follow-up of policy recommendations. Not an ex-post analysis; looked at whether issues were covered. - FSAP Case study: FSAP coverage—six-country case study covering three consecutive Article IV consultations over 2008–10 (Canada, Switzerland, Honduras, Thailand, Botswana, and Cameroon). Considered whether FSAP findings were integrated in Article IVs in years following an FSAP. *Italic: Source — _082611a - introduction of a Financial Surveillance Group—an interdepartmental forum for sharing information,* ### 11. The coverage of financial sector surveillance issues is variable. Both the broad ### 11. The coverage of financial sector surveillance issues is variable. Both the broad ### Coverage of financial sector issues in Article IV reports - Most Article IV reports contained information on the banking sector and issues related to regulation and supervision; reports were typically informative about recent financial sector developments. - Coverage of non-bank financial institutions (NBFIs) and markets: - AEs: higher coverage; NBFIs and markets often discussed (NBFIs 52 percent and 28 percent; and markets 52 percent and 11 percent respectively). - EMs and LICs: coverage tails off. - For AEs discussion of NBFIs was typically limited to a general discussion of the insurance sector or pension funds. - Broader discussion of the impact of less-formal and/or “shadow” entities was virtually non-existent in Article IV reports. - Lack of coverage of NBFIs and markets for LICs may be appropriate where markets are nonexistent/underdeveloped, but LIC financial sectors can still be a source of risks and proper functioning financial sector is important to support growth. - For frontier markets the focus on financial sector issues should be increasing; Article IV reviews suggest reports for these countries focused solely on the banking sector. ### FSS case study: scope and depth across five surveillance aspects - Five key aspects reviewed: regulation and supervisory framework; cross-sector linkages and inward spillovers; outward spillovers; crisis prevention policies; crisis management policies. - Findings: - Almost universal coverage of regulation/supervisory issues across the 17 FSS cases. - Most reports covered inward spillovers among the 17 FSS cases (depth varied). - Broader Article IV review found only passing reference or no reference to inward spillovers in almost two thirds of reports. - Coverage of crisis prevention and management policies was patchy: discussed in 11 and 9 reports respectively out of 17. - Very limited coverage of outward spillovers. ### Risk identification and transmission channels - Improvement over time: - In 2010 most reports in the FSS case study included some discussion of risks and vulnerabilities to the short-term outlook arising from financial sector and macro-financial factors. - Comparison with 2007 shows progress: 2010 reports identified a wider range of more specific risks (see Box 4). - Box 4 — Progress in Risk Identification 2007–10: - In 13 out of 17 cases the discussion of risks and their potential implications was more extensive in 2010 than in 2007; exceptions: India, Korea, Peru, and Botswana (similarly detailed, focus changed). - Examples where 2010 coverage was more extensive: - Cameroon: 2010 discussed risks posed by excessive concentration of bank exposures and inadequate supervisory standards; recommended remedial policy actions. - Philippines: 2010 highlighted interest rate and concentration risk, need for risk-based capital requirements, challenges of managing capital inflows, potential risks from an asset price bubble. - Spain: 2010 included more extensive discussion of risks and potential spillovers from the Spanish banking system to Europe. - Switzerland: 2010 highlighted reliance on wholesale funding of two large banks, impacts of change in Core Tier 1 definition and ring-fencing, cross border exposures to Emerging Markets and Europe, and risks in insurance and pension sectors. - Transmission channels coverage remains patchy: - Broad Article IV review: better coverage of threats the macro-economy poses to the financial sector than coverage of financial sector risks transmitting to the real economy — only 40 percent of cases reported on the latter. - FSS case study: coverage of financial sector risks to the real economy is uneven; in almost half of the 17 cases discussion was limited to one or two areas of the many possible consequences (fiscal costs, debt levels, growth, employment, interest rates, exchange rate, prudential policies, contagion). - In six cases reports did not permit a conclusion about whether the financial sector was a potential source of macroeconomic or external instability, typically reflecting insufficient analysis of risk transmission and sometimes lack of discussion of macroeconomic impact. - Discussions of potential contingent fiscal costs and growth/employment implications were covered in only four cases. ### Good practice examples of coverage linking financial risks to the macroeconomy (Box 5) - Iceland: - Thorough review of financial sector developments and private debt restructuring progress. - Highlighted three medium-term challenges: i) generate conditions to grow out of large post crisis debt, ii) adjustment measures to stabilize public debt (with consideration of growth impact), iii) overhaul policy framework to avoid repeating pre-crisis mistakes and ensure robustness to shocks. - Selected Issues Paper examined external debt sustainability, interest rate and exchange rate risks, corporate debt structure and sovereign risk; a contingent claims approach examined three risk scenarios (variations in fiscal consolidation path, Icesave outcomes, contingent liabilities from public enterprises) and effects on sovereign spreads. - Korea: - Discussed how pressures in Greece increased risk-premia for Korea-related exposures. - Noted indirect risks to banks reliant on wholesale funding and potential knock-on effects on the corporate sector given large dollar-denominated rollover needs. - Discussed possibility of amending inflation targeting to explicitly account for asset prices. - Peru: - Discussed challenges from easy external financing and renewed capital inflows; focused on sequencing of policy normalization and complementary tools to prevent credit and asset booms. - Selected Issues Paper reviewed cross-country experiences with sustained large capital inflows and policy responses. - Reviewed experience with dynamic provisioning and a reform agenda to reduce dollarization. - Factors enabling good coverage: - Mission Chiefs prioritized financial sector issues early, developed integrated agendas drawing macro-financial linkages, and devoted resources to research. - In two of three cases MCM economists joined mission teams; in one case included a former head of bank supervision and Legal Department support on private debt restructuring and bank resolution. - In some cases reliance on in-house Area Department expertise, non-MCM team members developing necessary skills, availability of cross-country work, active interest of country authorities, and Fund programs or pilot formats facilitating thematic presentation and candor. ### Cross-border linkages and spillovers - Further progress needed in assessing cross-border linkages and spillovers. - Cross-border linkages: - Broad Article IV review: contagion risks and cross-border spillovers mentioned in three quarters of AE reports, just over half of EM reports, and around a quarter of LIC reports. - FSS case study: risk and impact of contagion across domestic sectors or cross-border (mainly inward spillovers) mentioned in ten out of the seventeen cases; depth often uneven with many passing mentions. - Spillovers: - Broad Article IV review: lack of systematic discussion of inward spillovers; for systemic cases inward spillovers were covered in 39 out of 50 reports, but in 22 reports there was only a passing reference. - FSS case study: outward spillovers covered in only two cases (Spain and Russia). - Spillover Reports documented outward spillovers in five systemic economies in 2011. - Next steps for such analysis discussed in the 2011 TSR Overview Paper. ### Recommendations to support a risk-based approach (Section D) - Greater use of the vulnerability exercises (VEs) in bilateral surveillance as a complement to desk risk assessments: - Recommendation from Integration of Financial surveillance in Article IV (2009) was to consistently integrate findings from VEs into bilateral surveillance. - Use of VEs in Article IVs has been limited so far; dissemination of tools used in VEs and EWE should be stepped up to increase Area Department ownership and broaden use. - Greater use could be made of micro-financial/regulatory insights from the FSB in the context of the EWE. - Use multilateral surveillance risk analyses more widely as inputs into stress testing: - Downside risk scenarios developed for the GFSR and WEO, and country-specific risks from VEs, could be used more routinely in bilateral surveillance as the basis for staff stress tests and inputs for authorities' stress tests. - Incorporate these scenarios as downside and/or tail risk scenarios in risk-assessment matrices of FSAPs; encourage authorities to share stress test results. - More attention to country-level macro-relevant risks: - Develop a matrix with macro-relevant risks (RAM) in the Article IV report to think through macroeconomic risks and implications, especially risks related to economic agents' balance sheets and asset bubbles. - Regular attention to supervisory institutions and the regulatory framework; FSAPs are mandatory for systemic economies to help detect risks. - Strengthened recognition of financial interconnectedness: - Better take into account interconnections and consequences for country-level financial sector analysis. - Further work on financial interconnections and development of doctrines on financial stability–relevant developments (e.g., on new financial instruments). - Increase interdepartmental coordination: - Existing fora: weekly Surveillance Group meetings led by FDMD; monthly Financial Surveillance Group meetings; collaboration on LIC issues through Fund-Bank LIC Financial Group. - Consider forming “colleges”/groupings of staff for countries with strong financial sector linkages (examples cited: Euro Area/Swiss/HK/Singapore/UK/US; Bahrain/GCC with funding-relevant Western European countries; Caribbean with Canada) with support from functional departments. - Purpose of groups: set program of work on issues of common interest, enable deeper analysis of risks and transmission channels, inform policy recommendations, pool expertise, develop peer advice/reviews early in Article IV process, and foster earlier awareness of cross-jurisdiction developments. - Greater use and dissemination of tools and models (Box 6 highlights tools and rollout): - VE-specific financial sector rating tracks vulnerabilities comparable across peers and over time. - VEA models analyze finance-to-finance risks, cross-border exposures, banking crises, and macro-financial linkages. - Tools include: Analysis of Large and Complex Financial Institutions (LCFIs); Spillover and Contagion Tools; asset price, market valuation, and bubble identification tools. - Recommendations for rollout: - Formalize systematic use of financial sector ratings to prioritize discussions and track vulnerabilities while preserving confidentiality. - Encourage greater use of VEA models in bilateral surveillance for tail risk exploration; increase internal dissemination and vetting. - Integrate VEs and promote Area Department involvement and buy-in. - Disseminate downside scenarios from the EWE to staff and country teams for use in stress testing and scenario analysis. - External consultants recommended greater use of EWE/VEs in surveillance. _Italic: Source: _082611a - 11. The coverage of financial sector surveillance issues is variable. Both the broad_ ### Box 7. Good Practice—Financial Interconnectedness Applications ### Box 7. Good Practice—Financial Interconnectedness Applications ### Financial interconnectedness applications: use and improvements - The network approach captures extent of cross-border inter-linkages and has been used in a handful of Article IV reports and in policy work/multilateral surveillance. - Country applications cited: - Bahrain (2010 AIV) used a network approach to study cross-border exposures and risks to the GCC countries and those emanating from Western Europe. - The Netherlands (2009 AIV) simulated impact of a shock in one (or more) countries with significant financial linkages and associated “domino effects”; found losses for Dutch banks could be potentially large (up to 25 percent of GDP) and that contagion from a shock in the Netherlands would be largely contained to Europe. A similar approach was used in the Germany, Finland, and Sweden 2010 Article IVs. - Luxembourg (2011 FSSA) explored cross-border financial implications in the context of FSSA. Spillover Reports for five systemic economies are experimenting with this approach. - Policy papers, such as the mandatory FSAP paper, identified 25 systemic financial jurisdictions using the financial network and interconnectivity method; follow up work extended financial interconnectedness to explore implications for financial and real linkages. - Improvements underway: - An early warning system for systemically important banks‘ (SIBs) has been developed and will be extended to other SIFIs over time. - Measurement of cross-border exposure for SIBs is being improved. - The FSB has on its agenda further work on non-bank systemically important financial institutions (SIFIs) and has set up a task force looking at monitoring and regulatory frameworks for the shadow banking sector. *Source: _082611a - Box 7. Good Practice—Financial Interconnectedness Applications* ### Follow-up on policy recommendations: findings and options - Findings on specificity and follow-up: - Only around half of reports in the FSS study included a sufficient rationale for financial sector policy recommendations. - Where there was a recent FSAP (or Fund program), policy recommendations were suitably specific. - FSAP case study: out of 6 cases, in three coverage of recommendations dropped off in the year following the FSAP; in one case it dropped off two years later. - FSS case study: out of 17 cases, only 5 mentioned previous FSAP policy recommendations. - Description of composition of reforms, magnitude, and timing was much more specific in program/vulnerable cases (e.g., Kazakhstan and Iceland). - Options to keep stability assessments current and policy recommendations specific: - Increase frequency of stability assessments. - Have missions focused on one aspect of stability. - Rebalance resources between FSAPs and Article IVs (see Section VI). ### FSAP integration with Article IVs and the Risk Assessment Matrix (RAM) - RAM usage and recommendations: - The RAM has become a compulsory diagnostics tool in FSAPs. - A typical RAM lists key risks to financial stability of an individual country and provides a qualitative assessment of likelihood and impact, classified as low, medium and high, to provide a basis for stress-testing exercises. - The RAM should cross reference risks highlighted in the VEs to ensure consistency. - A RAM-like framework focusing on both macroeconomic and financial stability risks would be useful for Article IV consultations to help ensure follow up on previously identified risks and policy recommendations and promote regular discussion with country authorities. ### Analytical toolkit: expansion, usage, and improvements - Recent expansion and slow uptake: - Analytical toolkit has expanded in recent years, but further efforts are needed to support broader use. - Over the last three years, staff strengthened the analytical toolkit for financial surveillance (Box 8). Dissemination of best practices and training efforts are continuing, but use in surveillance has been filtering through slowly. - Usage findings from Mission Chiefs and Article IV review: - Mission Chiefs report Financial Soundness Indicator (FSI) tables are by far the most commonly used tool. - About a half of respondent mission chiefs reported using stress tests and scenario analysis. - Market-based indicators were used by only a third of the mission chiefs that responded. - Review of 50 Article IV reports and case studies: inclusion of FSI tables and qualitative descriptions of FS structures in most reports but significantly less use of stress tests or analysis of contagion or spillovers. - Box 8: Key analytical tools described: - Financial Soundness Indicators (FSIs): show how various risks build up over time; allow comparisons vis-à-vis historical or peer country averages; complement higher frequency and more forward looking indicators. - Market-based Indicators: include equity prices, credit spreads, credit ratings and other indicators where available; used to extract market perceptions, risks, and expectations. - Stress Testing (Model-based Approach and Tools): gauge impact of shocks on financial system and macro-financial linkages; tailored to country-specific circumstances. - Balance Sheet Approach for the Corporate and Banking Sectors: assess different types of risk exposures in an individual country. - Broader Institutional and Policy Analysis: complements quantitative indicators; builds on assessments of compliance with standards and codes; includes guidance on sovereign liability management, restructuring, debt market issues, management of foreign currency reserves and other sovereign assets, and coordination between asset and liability management. - Scenario analysis can be conducted using two global macroeconomic models. - Steps suggested to improve toolkit accessibility and use: - Consolidate and vet tools to reduce duplication and guide usage; greater vetting and out-of-sample testing to discriminate among tools. - Develop easy-to-use tools and standardized templates (e.g., balance-sheet based standardized template to be added to a country‘s macro framework; incorporate contingent claims in DSA; use cross-border tools such as the bank contagion module more widely for systemic countries). - Develop stress testing methodologies for use in a broad range of countries. - Increase dissemination (tools used in VEs and EWE) and step up training; make basics of the financial sector compulsory for entry level staff (similar to the financial programming course). ### Data limitations: priorities, progress, and remaining gaps - Mission Chief survey priorities: - Mission Chiefs see data on cross-border exposures and sectoral balance sheets as particularly problematic and call for a cross-country approach to address them. - Survey respondents could pick up to 3 data areas for improvement; specific country needs vary with financial sector development. - Quarterly data areas and other priorities highlighted (chart labels): Quarterly external debt by remaining maturity; General government debt data; More frequent CPIS data; More frequent general government fiscal data; More detailed IIP data; Real estate property prices; Quarterly sector balance sheet data; Quarterly data on cross-border exposures. - Current status and recommendations: - Financial sector data shortcomings should be identified in the statistical issues appendix to the Article IV; the 2008 review suggested this appendix be properly focused on data shortcomings with significant implications for surveillance and be expanded to cover financial sector data issues when warranted. - It is rare for Article IV reports to explicitly highlight financial sector data limitations—only 5 reports out of 50 made any comment about adequacy of financial sector data; in three of those data was assessed as particularly weak. - Recommendation: develop a modernized template for the statistical issues appendix to ensure better coverage of financial sector issues and make clear when insufficient information prevents a good determination of financial sector stability. - Recommendation: bring forward the review of data provision for surveillance to 2012 to sustain momentum on filling data gaps. - Progress on key data gaps, including G-SIFIs: - Recent progress includes agreement in fall 2010 to make the Coordinated Portfolio Investment Survey a semi-annual survey; release in December 2010 of first results from the Coordinated Direct Investment Survey; and proposals to enhance BIS International Banking Statistics. - In February 2011, the IMF (STA) and the OECD co-hosted a sectoral accounts conference that agreed on a minimum set of internationally comparable sectoral accounts. - In April 2011 the FSB Plenary agreed that work on common templates related to G-SIFIs proposed by the FSB Working Group should progress and a consultation process started; intention is to have a final decision on the data templates in the fall of 2011. - Depending on decisions in 2012, the IMF may gain access to G-SIFIs individual financial institution to aggregate country data (the so called I-A data) in 2014. The data will have restricted access and strong confidentiality mechanisms; key messages from this information are intended to be used effectively in bilateral and multilateral surveillance. - Note: G-SIFIs data access raises sensitive legal and administrative issues for further investigation. - Remaining data inadequacies: - Data on NBFIs such as insurance, mutual funds and pension funds is either out of date or not easily available even for some of the twenty five economies identified to have systemically important financial sectors; NBFI information on other economies is sparse. - June 2011 Progress Report for the G-20 Data Gaps Initiative highlights efforts to improve availability of data on activities of NBFIs and to make this a priority over the next twelve months. - The global funds industry (a proxy for the shadow financial sector) had total assets of about $25½ trillion at end-June 2010 down from $29¼ trillion at end 2007 (measured as the assets under management of domiciled funds); getting a handle on this sector remains critical. - The FSB has a work agenda for non-bank SIFIs and has set up a task force to look at oversight, monitoring and regulatory frameworks of the shadow banking sector. - Recommendation: bringing forward the review of data provision for surveillance will help the Fund get a more comprehensive view of data needs and ways to satisfy them. ### Resources: staffing, expenditures, and deployment - Forms of expert support for bilateral surveillance: - (i) participation in area department missions; - (ii) HQ-based back up support/cross-country analysis (e.g., EUR/MCM collaboration on stress testing); - (iii) MCM led missions to conduct mandatory FSAPs; - (iv) other: technical assistance feeding indirectly into surveillance. - Training on financial sector issues is provided by both MCM and INS; training stepped up significantly in 2008 (to over 1500 days from 1200 in 2007) and remained at this level since, accounting for around 40% of training days for INS in 2010. - Expenditures and time allocations: - Financial sector surveillance expenditures rose from $21.5 million in FY2007 to $22.5 million in FY2010. - As a share of expenditures on surveillance, financial surveillance has remained relatively stable hovering at around 15 percent range since FY2007. - Time devoted by MCM to Article IV fell by 15% between 2009 and 2010 from 42,000 hours to 36,000 hours, whereas time devoted to FSAPs increased by 13% from 49,000 hours to 56,000 hours. - While more than half the spending on financial sector surveillance has gone to EMs, since the financial crisis there has been an increase in the amount of resources going to AEs and a decrease in resources for LICs. - Figures on a different basis suggest spending of $26mn in FY 2011. - Note: There is a structural break in budget data between FY2010 and FY2011 with the introduction of a new time reporting system which could distort direct comparison of 2010 and 2011 data; a structural break could distort direct comparison of FY2010 and FY 2011 numbers (hours spent in FY2011 on the FSAP were 80,000 and on Article IV 34,000). - TA resources are not included in the expenditure estimates for financial sector surveillance although indirectly TA can help effect policy change and contribute to strengthened surveillance; since TA is concentrated in EMs and LICs the totality of financial sector work contributing surveillance in these cases is likely to be underestimated. - Forward-looking consideration: - Further thought could be given to how financial sector resources are deployed to make financial stability a core aspect of regular surveillance work. *Source: _082611a - Box 7. Good Practice—Financial Interconnectedness Applications* ### 36. The introduction of the mandatory FSAP for 25 systemically important financial ### 36. The introduction of the mandatory FSAP for 25 systemically important financial ### Frequency and resource implications - The introduction of mandatory FSAPs for 25 systemically important financial sectors every five years addresses a gap but "is likely to be insufficient to guarantee that emerging risks are spotted in time." - Increasing the frequency of FSAPs for these economies from five to three years would entail resource costs of around $2.8 million a year. - Footnote detail: Assumes that countries with systemically important financial sectors have stability assessments every 3 years, and all other countries have FSAP updates at the current frequency of every 6–7 years. The cost of each mandatory stability assessment is set at the average of a G-20 FSAP update cost. ### Alternatives and lighter approaches within Article IV surveillance - Lighter ways to ensure routine financial stability assessments could be: - Focused, routine assessments of critical issues within Article IV surveillance. - Ensuring at minimum the continuous participation of a financial sector expert in country teams for members with systemically important financial sectors. ### Options to better integrate financial stability analysis into Article IV surveillance - Objective: better integrate stability analyses into Article IV reports and strengthen the link between macro and financial surveillance. - Possible organizational/options presented: - Ensuring regular support by a financial sector expert at least in systemic cases. - Evidence: In 2010 MCM participated in 17 out of 25 Article IV surveillance missions to these economies, implying that making such participation standard would impose additional resource costs. - Mainstreaming financial stability analysis: - Develop further capability for (non specialist) Fund staff to undertake financial stability analysis to alleviate tension between resources devoted to systemic and non-systemic cases. - Streamline the analytical toolkit and step up training. - Possible measures: introduce mandatory financial sector training for new staff; develop a new immersion course (similar to financial programming) aimed at IMF staff focusing on basics including stress testing. - Promote greater mobility for staff with specialist skills between functional and area departments (and vice versa) to break down silos and spread knowledge. - Reconfiguring resources: - Reconfigure financial sector expert resources to significantly build financial analysis capability in Area Departments, increasing flexibility to allocate resources where needed from the perspective of risks to members‘ economies or the system as a whole. - Retain specialist resources: - While building capacity in departments, Mission Chiefs may need to draw on technical expertise of MCM for complex issues; specialists with extensive experience remain necessary. - More radical change: - Attach all bilateral surveillance resources to Area Departments, with MCM refocusing on global systemic risk advisory issues and coordinating with other bodies. - Financial experts in Area Departments would liaise with MCM and colleges of mission chiefs to keep Area Departments up-to-date on global financial stability issues. ### Appendix I — The FSAP: scope and components - Established in 1999; comprehensive, in-depth analysis of a country‘s financial sector. - Responsibility: - Joint IMF and World Bank in developing and emerging market countries. - Fund alone in advanced economies. - Since 2009 FSAP components: - Financial stability assessment — responsibility of the Fund. - Financial development assessment — responsibility of the World Bank (in developing and emerging market countries). - Modular assessment option so stability or development assessments can be completed separately. - Financial Stability Assessment: - Evaluates source, probability, and potential impact of main risks to macro-financial stability in the near-term. - Examines soundness of banking and other financial sectors via quantitative and qualitative analysis. - Assesses policy framework effectiveness and quality of bank, insurance, and financial market supervision against accepted international standards. - Evaluates authorities‘ capacity to manage and resolve a financial crisis, including supervisors, policymakers, and financial safety nets. - Can include detailed assessments of compliance with Standards and Codes. - A Risk Assessment Matrix has been added to strengthen risk identification, linkages, and flexible modular assessments. - Financial Development Assessment: - Examines quality of legal framework and financial infrastructure (payments and settlements) to identify obstacles to competitiveness and efficiency. - Examines contribution of the sector to economic growth and development. - Emphasizes access to banking services and domestic capital market development in low-income countries. ### Appendix II — FSS case study and integration with Article IV - Heat map construction (coverage dimensions): - FS coverage: sectors covered; whether coverage of recent economic developments/policies is informative about financial stability; core surveillance issues (regulation/supervision, crisis prevention, crisis management, contagion, outward spillovers); financial sector development issues. - Risk identification: whether reports identify risks and whether buffers are available to cope with shocks. - Two-way transmission channels: breadth of discussion of potential impact of financial sector developments on the macro-economy and vice versa. - Toolkit usage: tools covered out of 9 categories (financial soundness indicators, market indicators, balance-sheet analysis (BSA or CCA), stress tests, scenario analysis, transmission channels/feedback loops, cross-border analysis, network analysis, other). - Policy specificity and follow up: whether reports include sufficient rationale for financial sector policy recommendations, timing and pace of reform. - FSAP case study for 6 economies: integration of FSAP findings in Article IV reports is categorized as Integrated, Some Integration, No Integration, or No AIV report; t corresponds to year of publication of FSAP and Article IV for each country example. ### Appendix III — List of analytical financial sector tools for surveillance (major categories and examples) - I. Financial Soundness Indicators (FSIs) - Core set: banks‘ exposure to risks and capacity to handle solvency and liquidity shocks. - Encouraged set: covers banking system, key non-bank institutions, and non-financial sectors (e.g., corporates, households, real estate). - II. Market-Based Indicators - Contingent Claims Analysis – Distance to Default Tool: Excel and RATS program for distance-to-default across banks, portfolios, sectors. - Real Estate Vulnerability: indices for residential and commercial real estate vulnerabilities (price misalignment, impact on activity, household balance sheets, mortgage market characteristics, rents, vacancy rates, construction activity). - III. Stress Testing (Model-Based Approaches and Tools) - Stress tests: sensitivity tests (single risk factors) or scenario tests (multiple internally consistent risk factors); bottom-up (institutions) or top-down (aggregated or bank-by-bank). - Balance-Sheet Risk Approach (BSRA): combines balance sheet with market data to construct marked-to-market values and forward-looking measures of credit quality. - Macro-Financial Stress Testing — Non-Parametric Approach: CoPoD and CIMDO methodologies for incorporating macro shocks and recovering portfolio multivariate distributions. - Fundamentals-Based Credit Risk Modeling — Parametric Approach: estimates default probabilities (PDs) and maps to credit losses. - Credit Risk +: estimates distribution of portfolio losses, expected/unexpected losses, and value-at-risk for capital and provisioning assessment. - IV. Balance Sheet Approach for Corporate and Banking Sectors - Balance Sheet Approach (BSA): matrix of key indicators to assess currency mismatches and capital structure mismatches. - Moody’s-KMV/CCA Risk Tools: assess needed bank capital to target ratings/default probabilities and estimate expected losses and contingent liabilities. - Corporate Sector Vulnerability Utility: indicators from basic balance sheet info and combined balance sheet/market data (stock valuation, default probability, investment efficiency). - Cross-border Banking Contagion Model: downstream/upstream vulnerability measures and scenario analysis of shock propagation, deleveraging, insolvency, and policy recapitalization effects. - V. Broader Institutional and Policy Analysis - Risk Measures for Public Debt (MCM AL): estimate exchange rate, interest rate, and refinancing risk exposures and simulate debt management strategies. - Crisis Risk Models — Estimating the Likelihood of a Crisis: threshold-based indicators for capital account crises (emerging markets) and financial crises, sharp growth slowdown, sharp fiscal consolidation (advanced economies); construct weighted averages of risky indicator breaches to assess vulnerability. - Scenario Analysis using GPM and GIMF: - Global Projection Model (GPM): monetary business cycle model for GDP, inflation, short-term interest rates, exchange rates, unemployment, and bank lending. - Global Integrated Monetary and Fiscal Model (GIMF): multisectoral, multiregional model with nominal and real rigidities and fiscal sector detail to simulate shocks and policy packages, including fiscal consolidation design. ### Chapter III — Fund advice on stimulus and exit policies: Main findings and key lessons - Main Findings: - Fund advice at the onset of the crisis was bold, particularly on stimulus, and overall seen by the Membership as timely and adapting to changing circumstances. - Broad consistency existed between various surveillance products. - Messages on stimulus were very clear and the size of the advised stimulus was broadly informed by sustainability considerations based on available information at the time; however, linkage with implicit liabilities due to financial sector assistance could have been made more explicit in some cases. - Advice on exit was more nuanced, reflecting complexities in outlooks and divergence in recovery speed across countries; recommendations had to balance support for recovery and sustainability considerations. - While some divergences existed between Fund advice and authorities‘ views, overall policy stance was broadly in line with Fund advice. - Multilateral surveillance products had explicit spillover analyses, but coverage of spillovers and cross-country analysis in bilateral surveillance was uneven, including for systemically-important countries. - Key Lessons: - Strong impact from a clear multilateral message to the membership. - Importance of thinking through risk scenarios and accounting for macro-financial linkages, e.g., possible impact of financial sector developments on fiscal balances. - Need to better integrate spillover analysis into Article IV consultations. *Source: _082611a - 36. The introduction of the mandatory FSAP for 25 systemically important financial (PDF).* ### 1. This background study assesses the Fund’s multilateral and bilateral policy ### 1. This background study assesses the Fund’s multilateral and bilateral policy advice on macroeconomic stimulus/exit related to the global crisis ### Scope and purpose - Covers the period from January 2008 to April 2011. - Prepared by Gilda Fernandez, Toshiyuki Miyoshi, Kingsley Obiora, Hitoshi Sasaki, and Bert van Selm. - Assesses perceived timeliness of Fund policy advice on stimulus and exit, consistency of approach, tailoring to country circumstances and risks, attention to spillovers analysis, and candor (whether advice could differ from authorities‘ intentions). - Notes that it is too early to assess the adequacy of Fund advice; adequacy is beyond scope and could be addressed in future reviews. ### Key multilateral messages on stimulus and exit - The Fund called early and strongly for global macroeconomic stimulus in response to the global downturn (first public call at Davos, January 2008; reiterated April 2008). - Multilateral calls were clear but nuanced: an unequivocal call for global stimulus in press statements and multilateral products was linked to more tailored, country-specific guidance based on availability of fiscal space, cyclical positions, inflationary pressures, and debt levels. - Initially targeted mainly at advanced countries; as conditions worsened after September 2008, call broadened to emerging economies and LICs with adequate policy space. - At the G-20 leaders‘ summit in November 2008 the MD called for a coordinated action plan to achieve a global fiscal stimulus equivalent to 2 percent of GDP. - Multilateral advice included both quantitative and qualitative dimensions, including composition of fiscal stimulus and emphasis on long-term fiscal challenges and medium-term consolidation. ### Evolution toward exit strategy guidance - 2009: Fund urged preparation of post-crisis exit strategies; Fiscal Monitor called for measures to reduce and sustain debt ratios. - Fall 2009 WEO: warned against premature exits but urged preparation for orderly unwinding of extraordinary public intervention. - Spring 2010 WEO: urged countries suffering large increases in risk premia to begin fiscal consolidation; most advanced countries encouraged to consolidate in 2011. - Fall 2009 WEO: pace of unwinding central bank balance sheets depends on market normalization and types of interventions. ### Differentiation of exit advice - As recovery speed diverged across countries, short-term exit messages became more differentiated. - Fund calls to prepare withdrawal of stimulus came early (2009), but timing of exit balanced fragile recovery considerations against sustainability on a case-by-case basis. ### Multilateral to bilateral translation - Staff prepared Board papers, Policy Review Notes, Staff Position Notes to translate multilateral messages into operational, country-specific terms to guide Article IV consultations. - Little evidence of inconsistencies between multilateral and bilateral advice on stimulus and exit policies. ### Clarity and timeliness of bilateral advice - Bilateral advice on fiscal and monetary policy generally: - Clear, substantiated, sufficiently detailed, placed in a medium-term context, and included discussion of policy impacts. - Magnitude, timing, and composition of proposed fiscal changes were well-articulated and justified. - Where exit strategies were recommended, these were generally elaborated with some detail, including timing. - Article IV review result: in countries where fiscal and monetary policy loosening had been implemented, staff reports elaborated on exit strategies, including timing, in most cases (70 percent). - Perceptions of timeliness and responsiveness: - Country authorities and Executive Directors (EDs) rated timeliness as 3.7 (on a scale of 1 to 5) for both groups. - Ratings that advice took into account changing domestic and global conditions: 3.9 for country authorities and 3.8 for EDs (scale 1 to 5). - Country authorities rated discussion of fiscal developments and policy as contributing to understanding: 62 percent. - Monetary policy contributed to understanding for 38 percent (somewhat less positive than 2008 TSR, reflecting Euro Area-level coverage). ### Attention to country-specific circumstances and risks - Most country advice took into account debt levels and inflation outlook; financing constraints and financial sector vulnerabilities were considered to a lesser extent. - External consultants on IMF surveillance in the Euro Area noted that advice on fiscal stimulus was not sufficiently differentiated across countries. - Multilateral emphasis on employment preservation and targeted fiscal measures was less evident in bilateral surveillance; explicit discussion of redistributive effects and protection of vulnerable groups in Article IV reports was rare. - Examples: 2009 Article IV consultations with Australia and China advised income transfers for low-income households and the recently unemployed; 2010 consultations with the U.S. and the U.K. suggested targeted tax cuts to support low-income households and employment in significant downturns. - Impact on employment of exit policies was discussed in 10 percent of the countries covered by the Article IV review. ### Financial sector contingent liabilities and fiscal advice - Bilateral advice considered contingent liabilities where relevant, particularly in post-Lehman period for countries with large financial sectors (Ireland, Spain, U.K., U.S.). - April 2011 Fiscal Monitor country-by-country net deficit increasing direct cost (cumulative since beginning of crisis) reported as: - Ireland: 29 percent of (2010) GDP - Spain: 2.0 percent - U.K.: 6.0 percent - U.S.: 3.4 percent - Net cost was a small fraction of government guarantees and other financial sector support measures, which in some cases remained substantial. - Case studies showed post-Lehman staff reports flagged contingent fiscal liabilities, though linkage to fiscal stimulus recommendations was uneven (examples: Ireland, Spain, U.K., U.S.). ### Policy balance and country examples - Fund balanced strength of recovery with sovereign risks in exit advice: - Supported U.K. plans to frontload fiscal consolidation in 2010. - Advised the U.S. to maintain stimulus throughout 2010 and withdraw support in 2011 given differences in recovery assessments and potential sovereign risks. ### Analytical and guidance products used - Staff papers and notes provided analytical frameworks and guidance, including: - Board papers, Staff Position Notes, Technical Guidance Notes, Policy Review Notes (Staff Discussion Notes). - Examples include: Fiscal Policy for the Crisis (December 2008 Board paper), The Case for Global Fiscal Stimulus (March 2009 Staff Position Note), Unconventional Choices for Unconventional Times (November 2009 Staff Position Note), The State of Public Finances—Outlook and Medium-Term Policies After the 2008 Crisis (March 2009 Board paper), Exiting from Crisis Intervention Policies (January 2010 Board paper), Strategies for Fiscal Consolidation in the Post-Crisis World (February 2010), From Stimulus to Consolidation—Revenue and Expenditure Policies in Advanced and Emerging Economies (April 2010), Practical Guide to Fiscal Consolidation (June 2010 Policy Review Note), Exiting from Extraordinary Monetary and Financial Support (June 2010 Policy Review Note), A Practical Guide to Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates (January 2010 Technical Guidance Note). *Italic: Based on the IMF background study covering January 2008–April 2011 prepared by Gilda Fernandez, Toshiyuki Miyoshi, Kingsley Obiora, Hitoshi Sasaki, and Bert van Selm.* ### Box 4. The Fund’s Advice on Exits from Fiscal Stimulus: U.K. versus U.S. ### Box 4. The Fund’s Advice on Exits from Fiscal Stimulus: U.K. versus U.S. ### Summary of divergence in Fund advice - Fund staff advocated substantial medium-term fiscal adjustments for both the United Kingdom and the United States. - Near-term timing of fiscal exits diverged, reflecting different assessments of: - tail risks associated with a loss of confidence in the sovereign; - the degree of slack in the economy—the output gap in the U.K. was projected to be smaller than in the U.S. in the 2010 U.K. and the U.S. Article IV reports; - debt tolerance level—considerations that the U.S. is an issuer of the world‘s reserve currency and differences in the scale of possible contingent liabilities emanating from the banking sector. ### United Kingdom: advice, rationale, and safeguards - Staff supported the government‘s frontloaded fiscal consolidation plans set out in the 2010 Budget to reduce the risk of a costly loss of confidence in public finances. - In the 2011 Article IV consultation, staff concluded that strong fiscal consolidation that was underway would be appropriate, taking into account that the deviations from the economic trajectory that had been forecasted were largely temporary. - Staff supported the government‘s fiscal consolidation plans to balance the cyclically-adjusted current budget over a five-year rolling horizon—by 2015/16. - Staff assessed that “fiscal tightening will dampen but not stop growth as other sectors of the economy emerge as drivers of recovery, supported by continued monetary stimulus.” - Recommended safeguards against cyclical uncertainty included: - the free operation of automatic fiscal stabilizers in both directions; - temporary targeted tax cuts in the unexpected but possible case of a significant and prolonged downturn. - Staff concluded in the 2011 Article IV consultation that the authorities‘ planned medium-term fiscal consolidation was appropriate, quantified as: - a structural adjustment of about 8.0 percentage points of GDP over a 5-year horizon. ### United States: advice, rationale, and risks - In July 2010, staff recommended maintaining fiscal stimulus in 2010 as planned given the remaining weakness in demand, stubbornly high unemployment, and lingering financial strains. - Staff recommended in 2011 to start fiscal adjustment in FY2012 to guard against the risk of a disruptive loss in fiscal credibility and adopt a medium-term consolidation plan to stabilize the debt ratio by the middle of the decade and gradually reduce it afterwards. - Earlier guidance in 2010 called for making the then planned down payment (about 2 percent of GDP) on fiscal consolidation in 2011, with flexibility on the size of adjustment if risks materialize. - Subsequent policy developments: - In December 2010, the U.S. adopted a new stimulus package, the impact of which was considered small relative to its fiscal cost (January 2011 WEO Update), resulting in a change in the stance of fiscal policy, where the structural deficit in 2011 is now projected to widen rather than contract (April 2011 WEO). - Market concerns about the U.S. fiscal path rose since April 2011 given little evident progress in breaking the political stalemate over how to carry out needed fiscal consolidation. - In the concluding statement of the 2011 Article IV mission (June 2011), staff warned about possible unfavorable fiscal outcomes that could take the form of: - a sudden increase in interest rates and/or - a sovereign downgrade if an agreement on fiscal consolidation did not materialize or the debt ceiling was not raised soon enough. - Staff recommended a broadly uniform reduction of the federal structural primary deficit over the next five years within a fully-specified and politically-backed consolidation plan, with totals specified as: - total recommended reduction: 7½ percentage points of GDP; - equivalent pace: about 1½ percentage points per year. ### Comparative rationale and implications - Differences in advice on timing likely reflected: - higher perceived tail risk of a loss of confidence in the U.K. public finances, motivating frontloaded consolidation; - a smaller projected output gap in the U.K. than in the U.S. in 2010 Article IV assessments; - greater debt tolerance for the U.S. as issuer of the world‘s reserve currency and differences in contingent banking-sector liabilities. - Common Fund emphasis: - substantial medium-term fiscal adjustment for both countries to restore sustainability and reduce fiscal risks; - careful sequencing to balance near-term support for recovery with medium-term credibility. *Source: Box 4. The Fund’s Advice on Exits from Fiscal Stimulus: U.K. versus U.S.* ### 3. LICs are particularly vulnerable to external shocks. Over the past few decades, ### 3. LICs are particularly vulnerable to external shocks. Over the past few decades, ### LIC vulnerability to external shocks — key findings - LICs‘ economies have become relatively open and sensitive to commodity price movements, both on the import and export side. - International food and fuel price shocks can have severe consequences for the poor and often result in fiscal interventions which need to be well targeted. - External grants in LIC budgets amount to 4–5 percent of GDP, or about one sixth of total revenue. - Dependence on large and volatile aid flows represents an additional challenge for macroeconomic management. - Remittances can represent an important source of external inflows. - LICs tend to have weak coping mechanisms: - ineffective automatic stabilizers; - credit constraints for consumers, businesses and governments; - limited or absent access to international financial markets. - Surveillance needs to remain attuned to these issues. ### Adapting surveillance tools for LIC-specific issues - Standard surveillance tools should be adapted to address LIC-specific issues, recognizing differences in economic structure, institutions, and data and capacity constraints. - Financial sector surveillance and external stability/exchange rate assessments require particular attention. - The VE-LIC exercise could play a useful role in identifying spillovers on LICs and integrating them into bilateral surveillance. - More regular focus on LIC-specific issues in the Fund‘s multilateral surveillance could supply cross-country analysis to inform policy discussions. ### LIC multilateral surveillance — observations - The World Economic Outlook (WEO), Global Financial Stability Report (GFSR) and Fiscal Monitor are generally focused on advanced countries and emerging markets; emerging and developing economies are usually grouped together in data presentations. - Exception: Fall 2010 Fiscal Monitor presented LIC-specific data and policy discussions, including a short general discussion on medium-term fiscal trends in LICs. - During 2008–10, the WEO and GFSR dedicated a total of approximately 2 pages to LIC-specific discussions. - Survey evidence: WEO found useful by 100 percent of surveyed LIC country authorities; GFSR found useful by 67 percent. - Regional Economic Outlooks (REO) provide LIC-specific cross-country analysis with a regional focus; SSA REO regularly raises policy issues relevant to LICs in SSA. - APD REO over 2008–10 has begun to feature a section dedicated exclusively to LICs. - An interdepartmental LIC Consultative Group (begun in 2008) meets frequently to discuss key LIC-specific issues and coordinate projects. ### Recent IMF LIC-focused work and the role of VE-LIC - Recent cross-departmental papers and frameworks: - 2008: Food and Fuel Prices—Recent Developments, Macroeconomic Impact, and Policy Responses and An Update. - 2010: Emerging from the Global Crisis: Macroeconomic Challenges Facing Low-Income Countries. - Earlier papers: The Implications of the Global Financial Crisis for Low-Income Countries; International Monetary Fund and The Implications of the Global Financial Crisis for Low-Income Countries—An Update. - April 2010: Preserving Debt Sustainability in Low-Income Countries in the Wake of the Global Crisis. - 2010: Creation of VE-LIC framework to monitor vulnerability indicators in LICs. - Early 2011: Paper analyzing economic linkages between LICs and BRICs. - A dry run of the VE-LIC was presented to the IMF Executive Board in April 2011 in preparation for a full run ahead of the 2011 Bank/Fund Annual meetings. - Ongoing work: paper analyzing vulnerabilities of LICs in the face of recent and prospective commodity price rises using VE-LIC. - VE-LIC could regularize and consolidate policy work on cross-cutting issues, macroeconomic risks and vulnerabilities with a focus on tail risks, scenario analysis and debt vulnerabilities. - No additional resources required to integrate VE-LIC work into the work plan; it would replace previous ad hoc studies. ### Financial sector surveillance in LICs — key findings - Weak data complicate standard quantitative analysis, risk and vulnerability assessment using Financial Soundness Indicators and stress testing. - Capacity constraints, poor risk management, uneven implementation of regulations (e.g., definition of non-performing loans) complicate assessment of financial sector risk. - Weak institutions and legal and governance issues pose significant additional challenges. - Countervailing factor: relatively unsophisticated financial sectors (no complex financial products, limited reliance on wholesale funding) could make some aspects of IMF surveillance more straightforward. - Financial sectors in LICs have been deepening over the last decade (figures and charts referenced in source). - Financial sector development can increase growth by tapping domestic and foreign capital and allocating it more efficiently. - Development can also create new risks: thinner markets weaken transmission channels of macroeconomic policies and limit hedging capacity; a larger, more sophisticated and interconnected financial sector poses supervisory challenges. ### Recent severe bank problems in LICs — documented examples - Nigeria: - Very rapid credit growth of over 140 percent in 2008, largely used to purchase equities. - Cost of cleaning up balance sheets and recapitalizing troubled banks is estimated at 7.5 percent of GDP (see IMF CR 11/57). - Afghanistan: - Kabul Bank experienced a bank run in September 2010 after insider lending and risky real estate operations led to losses equivalent to more than 5 percent of GDP. - Kyrgyz Republic: - 2010 change in government exposed weaknesses in Asia Universal Bank, which had increased its share of system deposits to almost 50 percent in a short time span. - Nepal: - Regulatory and supervisory framework unable to keep pace with rapid financial sector growth; many banks now experiencing severe capital and liquidity problems with high systemic risks. - Democratic Republic of Congo: - Liquidation of Banque Congolaise after unsuccessful restructuring; potential adverse effects on fiscal balance and NFA estimated at about ¾ of a percent of GDP each. - Caribbean: - 2009 collapse of CL Financial Group continues to pose major challenges to the Eastern Caribbean Currency Union (ECCU), including some LICs. ### Assessment of Fund financial sector surveillance in LICs - Review of 50 Article IVs confirms assessment of financial sector risks and vulnerabilities and policy guidance is weaker in LICs than in advanced and emerging economies. - Need to go beyond narrow focus on banking soundness indicators and more consistently cover broader implications of financial sector development on growth and stability. - Bank failures in LICs suggest LIC-specific guidelines are needed to identify risks early and provide frameworks to cope with bank failures. ### Recommendations to strengthen LIC financial-sector surveillance - Develop simple and practical guidance to address key LIC-specific issues. - Establish conditions under which financial sector development in LICs reduces economic volatility to inform surveillance guidance. - Compile a basic list of red flag issues drawn from previous LIC bank and NBFI failures. - Provide LIC-specific guidance on resolving troubled banks in contexts with governance issues, lack of deposit insurance, or state-oriented banks. - Continue collaboration with the World Bank; IMF-World Bank LIC Financial Group under the FSLC could play an important role. - Maintain Fund focus on financial stability while the World Bank leads on financial sector development. ### Spillovers, supervisory cooperation, and resource constraints - Increasing integration of LIC financial systems at regional and global levels may create new potential risks and spillovers. - Monitoring developments in supervisory cooperation and assessing potential for spillovers in LICs should be an important element of surveillance. - VE-LIC spillover and scenario analysis could play a significant role in this monitoring. - Finite Fund resources for financial sector surveillance present challenges: - Provision of financial sector experts on Article IV mission teams strengthens surveillance, but MCM participates less frequently in LIC surveillance than in other country groups. - Need for clear guidance and consideration of ways to leverage scarce resources more effectively. - Monitor FSAP allocation to ensure commitments to systemically important jurisdictions do not excessively limit resources for LICs. ### Box 1 — Inward spillovers to LICs (summary of examples and mechanisms) - LICs are relatively open and sensitive to terms of trade and external demand changes; commodity price volatility has big impacts on growth and fiscal costs due to subsidy needs. - External flows (FDI, remittances, foreign assistance) are essential and often influenced by policies outside LICs. - Historically, spillovers came mainly through trade linkages and non-portfolio flows with direct consequences for GDP growth; increased financial integration raises the potential for capital-flow volatility spillovers. - Examples of spillover channels: - Textile sector: exchange rate and wage policy in large competitors (e.g., China, India) affect competitiveness of LIC exporters such as Bangladesh (three-quarters of exports in ready-made garments). - Global interest rates: increasing number of LICs issuing in international capital markets makes them sensitive to U.S. interest rate movements with potential fiscal and financial sector balance sheet effects. - Customs Union (SACU): revenue policy and revenue-sharing formulas in South Africa affect revenues for Swaziland, Botswana, Namibia and Lesotho; a fall in SACU revenues has resulted in large spillovers from South Africa to smaller members. - Regional financial integration: banks with regional interests can create spillovers through financial sector channels. - VE-LIC is being refined (including estimating elasticities to capture heterogeneity among LICs) to evaluate impact of global shocks and assess magnitude of spillovers from policies of systemically important countries. *Source: _082611a - 3. LICs are particularly vulnerable to external shocks. Over the past few decades,* ### 17. Exchange rate-related issues have received more attention in LIC surveillance ### 17. Exchange rate-related issues have received more attention in LIC surveillance ### Attention and methods used in LIC surveillance - Following the adoption of the 2007 surveillance decision, exchange rate-related issues have received more attention in low-income country (LIC) surveillance. - A review of a sample of 50 Article IV staff reports finds: - No quality differences between LICs and higher-income countries in assessing the appropriateness of the exchange rate policy and exchange rate level. - Greater use of country-specific adjustments in LICs. - Most LIC teams have been moving from traditional indicator-based approaches to more model-based CGER methods; there does not seem to be a noticeable difference in assessment methods between income groups. ### Application of CGER methodologies and robustness - Application of CGER methodologies in LICs yields less robust results than in other countries. - Working groups in the Africa (AFR) and Middle East and Central Asia Departments (MCD) found that in many cases CGER methods did not produce robust results across different specifications or consistent assessments across different approaches. - Research evidence: - De Bella et al. (2007) reviewed long-term REER estimations in staff reports and found that only about one third of the estimated coefficients for LICs (vs. two thirds for EMs) had both signs consistent with economic theory and statistical significance. ### Data weaknesses and technical difficulties - Data weaknesses make applying CGER methods in LICs technically difficult: - Length of reliable macroeconomic series is relatively short in many LICs, making it difficult to uncover long-run relationships between the equilibrium exchange rate and underlying fundamentals. - The CPI is often the only reliable deflator of nominal exchange rates but is a particularly poor measure of price competitiveness in the tradables sector in LICs. - Significant weaknesses in collecting and compiling required data reduce the robustness and meaningfulness of CGER estimates. - Structural breaks triggered by domestic political events or external shocks are more pervasive in LICs, often leading to abrupt changes in relationships among macroeconomic variables. ### LIC-specific structural challenges for CGER - LIC-specific characteristics that complicate CGER application: - CGER estimates rely on a stable relationship among the current account balance, net foreign assets, and the real effective exchange rate; many LICs face financing constraints limiting consumption smoothing while receiving substantial foreign aid and inward worker remittances that do not depend on the exchange rate. - CGER methods assume relative prices are free to adjust and that price signals lead to prompt changes in production and consumption; in many LICs, price controls exist and transmission of price signals to real variables is slow and partial. - LICs often have a less diversified export structure and many are commodity exporters; exogenous commodity price shocks or terms of trade shocks complicate exchange rate assessment, especially when data are weak. - Panel regressions across diverse countries diminish the relevance of estimated coefficients for individual LICs. ### Use of alternative methods and country-specific adjustments - Given CGER difficulties, country teams assess external stability in a broad context and use alternative methods: - CGER-based analysis is typically part of a comprehensive discussion of external competitiveness. - Traditional indicators (e.g., export market shares, business environment indicators) provide useful complementary information. - Country teams have made adjustments to CGER methods to address weaknesses: - Among all LIC staff reports under review, more than 60 percent made adjustments to the standard CGER methods. - Adjustments include adding LIC-relevant variables to reduced-form regressions, changing definitions of regressors, or adjusting the elasticity of the current account balance with respect to exchange rates. ### Recent progress in adapting CGER for LICs - The Research Department (RES) initiated a process in 2008 to build a larger and more consistent database for LICs. - Findings from that exercise: - The three external indicators (real effective exchange rate, current account, and net external assets position) can be explained by a broad set of economic fundamentals that differ from those used for advanced and emerging market countries. - Important LIC fundamentals include aid flows, domestic financial liberalization, removal of capital account controls, shocks, demographic measures, and the quality of institutions. - These factors should be appropriately controlled for when assessing exchange rate misalignments in LICs. - Area department initiatives: - MCD focused on oil-producing countries. - AFR focused on sub-Saharan Africa special factors, such as large aid and remittance flows, non-renewable resources, and export concentration. ### Remaining challenges and recommendations to strengthen LIC exchange rate assessments - Further progress is needed; data limitations and institutional weaknesses in LICs are likely to persist. - Recommended measures and practices: - Greater synergy in improving CGER methods: - Develop broad guidelines on how to adjust standard CGER methods for different groups of countries based on defining characteristics (e.g., non-renewable resource exporters, large foreign aid or remittance recipients). - Endorsement of standard adjustments would help balance country-specific circumstances and consistency across countries. - Staff reports should be more candid about the limitations of CGER methods and more cautious in identifying misalignments because applying CGER in LICs often leads to much higher margins of uncertainty. - Careful judgment is required to determine whether CGER methods are appropriate for a particular country: - The three CGER methods may point in different directions or produce widely varying estimated deviations from equilibrium. - Simple averaging of CGER results may be inappropriate; if none of the CGER methods generates reasonable estimates, staff may choose not to present these estimates. - A comprehensive evaluation of exchange rate misalignment in LICs should discuss consistency between CGER-type analysis and basic external sector indicators (dynamics of the current account balance and export market share, foreign exchange intervention, parallel market rates, and the accumulation of foreign assets) as part of a broad discussion of external stability. *Source: _082611a - 17. Exchange rate-related issues have received more attention in LIC surveillance* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_082611a.pdf_