Transcript

Transcript of an IMF Book Forum
Rules-Based Fiscal Policy In Emerging Markets
Wednesday, October 6, 2004
Washington, D.C.

MR. CARSTENS: Well, good morning, colleagues and friends. It is my pleasure to welcome you all to this forum.

We have the opportunity today to discuss an important topic, which is a topic of a new book edited by our good friend, George Kopits, which is entitled "Rules-Based Fiscal Policy in Emerging Markets: Background, Analysis and Prospects." The book looks like this [indicating]. It is a very nice print. I don't know what George did, but he managed to get an IMF book in hardcover, which is a major discovery for me that this type of printing is possible in the Fund.

Anyway, this book is the latest in a long list of contributions that George has made to the literature and debate on fiscal rules. Much of this research has taken place during his almost 30-year tenure at the IMF. Regrettably, from our point of view, he left his position as Assistant Director of the Fund's Fiscal Affairs Department at the end of last year in order to accept the very relevant position on the Monetary Council of the National Bank of Hungary. We are very pleased to have him back here today.

Although George wrote chapters for this book and provided editorial expertise, I believe that his most important contribution was in designing the incentives for the book's creation. By organizing seminars on fiscal policy rules in many countries worldwide, he provided the motivation for the contributing authors to write chapters. In my previous position as Under Secretary of Finance in Mexico, I had the pleasure of participating in an IMF seminar, which was largely organized by George, in Oaxaca, Mexico. Experts came from across Latin America, and the discussions were extensive and very fruitful.

One of the things that was apparent there, as in the chapters of this book, is that "fiscal policy rules" mean different things to different countries. What rules have in common is that they seek to define a permanent constraint on fiscal policy, to limit discretionary intervention, and thereby confer credibility on the conduct of policy. But the form of fiscal policy rules varies considerably across countries.

Rules may place limits on the government budget deficit, public borrowing, or public debt, and each of these concepts can be defined in a myriad of ways. They may target the federal government, subnational government, or both. Rules may be imposed as a constitutional amendment, a legal provision, or a policy guideline. There may be or may not be judicial or financial sanctions for noncompliance.

Such variation is inevitable and, in fact, is welcome. What works in one country may not work in another. In particular, what works in developed economies may not work in emerging market economies, which often face considerably greater macroeconomic volatility.

As we have seen in recent years, this inherent volatility combined with poor macroeconomic management can have devastating consequences for activity, employment, and overall welfare. I think that the studies collected in this book show that fiscal policy rules can be helpful in addressing the deficit bias that has been at the heart of recent crises in many emerging market economies. But as the authors point out, effective rules must take into account country-specific cultural, political, and economic considerations. They must be well designed. They must be supported by a robust institutional infrastructure, including a high degree of transparency in public finances. And they must be fully supported by the governing authorities and their constituents.

In my opinion, fiscal policy rules succeed when they serve as an instrument for garnering public support for a responsible fiscal policy. Fiscal rules can be thought of as a social agreement that fiscal discipline is a critical element of a country's good governance. And this is really the heart of what we call "institutional infrastructure" in this case.

We have seen it emerge with regard to monetary policy. It is now widely agreed that price stability is desirable and, consequently, central banks have been granted in most of the cases fuller autonomy from the political process. It is encouraging that we are moving in the direction of agreeing a specific role for fiscal policy and this way enhance certainty and credibility in the macroeconomic framework.

With these thoughts, I would like to turn the floor over to our very distinguished panelists. First, we will hear from our good friend Joaquim Levy, who is now Secretary of the National Treasury in Brazil. Joaquim spent six years at the IMF early in his career and has also held a number of economic posts in Brazil's federal government, including Deputy Secretary of Economic Policy at the Ministry of Finance and Chief Economist at the Ministry of Planning, Budget and Management.

We will also hear from Mr. Misra, who is the IMF Executive Director representing Bangladesh, Bhutan, his own country India, and Sri Lanka. Before taking up his post here a year ago, he was Special Secretary for Economic Affairs in India's Ministry of Finance. Prior to that, he held several high-level positions in state and municipal-level governments in India.

I regret that our very good friend Ngozi Okonjo-Iweala is unavailable to be with us today. Her very heavy schedule prevented her from being here. However, we are privileged to have in her stead Ismaila Usman, who is the IMF Executive Director representing 21 African countries. This constituency includes his own country of Nigeria, where he served as Minister of Finance and, for a decade before that, as Deputy Governor of the Central Bank of Nigeria. We are very pleased that he is able to join us, especially because it was a very, very tight schedule. He really is what we could call a pinch-hitter.

And, of course, our fourth panelist will be George Kopits.

Now, before giving the floor to Joaquim, we will ask our panelists to begin with 10- to 15-minute opening remarks, and at the end of the initial statements questions from the audience will be most welcome. The proceedings are being recorded so that a transcript can be posted on the IMF website, and so I will ask the panelists and the questioners to please use the microphones. Finally, we don't have copies of George's book available here today, but order forms are available just outside the room.

So, without further ado, I will ask Joaquim to kick off our event. Thank you very much.

MR. LEVY: Thank you. It's a great pleasure to be here, and certainly I think that I probably have only good things to say about rules-based fiscal policy, because I think they are actually a factor why I'm able to be here, after spending a number of days in the Annual Meetings. The simple fact that the National Treasurer can be away for such a long period of time says something about the effectiveness of these rules in Brazil.

I think that the experience of Brazil with these rules is extremely positive. Certainly it has endured the transition of government, actually has been strengthened in the last year and a half. I think that more and more society understands its importance. And I think that one of the reasons that it has proved so effective is that no matter how clever and well designed the law itself became, the real support came from the fact that this law, our Fiscal Responsibility Law, actually consolidated a number of practices, of learnings that had been accumulated in, say, four to six years since the beginning of the '90s. So when this law was proposed to parliament, there was a very qualified majority to support it. It was approved with a majority that would qualify it, particularly in the case of the lower house, as a constitutional amendment, although it's not a change in Constitution. It was something that was tested and it was well understood in many of its aspects before becoming law. Of course, there were innovations in the law itself, but the spirit was already quite ingrained.

Actually, this is the approach, I believe, the government is taking also with, for instance, the independence or autonomy of the central bank. Much more important than to vote something quickly is to get people used to what it means, and that has been the experience in the last few years with our central bank. A couple of weeks ago, we saw it again. We had an election this Sunday, but the central bank had no qualms to raise interest rates a week and a half before the election because it felt it was important. Otherwise, in a number of other attitudes and measures, the meaning of autonomy has been built. Of course, this works because there is strong support to maintain inflation under control.

I would say that in some ways the same approach has been taken, for instance, with respect to the cyclical surplus. We had a lot of studies and discussions about that. We talked about putting some sort of cyclical surplus for 2005. However, at the end, I would say it was thought it was a very nice construction, but maybe we're not ready. And that was good because now we are having some extra revenues, and without much ado, the government decided save them. The message is the good times are beginning and that's time to increase savings, that's time to increase the primary surplus. So that people in a very natural way started to understand the real importance for emerging countries that are subject to high volatility, to take advantage of the good times, not to spend more when thing begin to work well, not to try to solve all the repressed demand that does exist, but to save and to prepare themselves for more lean times.

So I think this construction, this institutional building up, is very important, and certainly it's more and more built over this rock, I could call it, that is our Fiscal Responsibility Law. This law, I believe most of you know, covers a range of aspects in terms of fiscal policy. It established annual and intra-annual targets for our main indicator, the primary result, and for other selected fiscal variables, with mechanisms of self-correction. That means that we have less chance of having slippages that you learn about when it is too late. Mr. Carstens mentioned my experience with the Fund. I remember a decade ago—and I mainly worked with Western Europe, in the European I department. I remember going to countries where the missions were now in the fall, and we arrived there and discovered that there was a slippage of a half percent of GDP or—I remember '93— in some countries it was more like 2 percent or 3 percent of GDP. That would just happen because they had been hurt by a recession and would start to adjust only too late. Of course, the outturn for the year would be almost impossible to be reached, and adjustment would drag through the following year.

In Brazil, we have reviews every two months to see if revenues are in line, if spending is compatible with the fiscal targets. At the beginning of the year, we establish a monthly schedule of spending, and you verify it every two months. And every four months I have to go to Congress and explain what's happening, if the budget is in line with the targets or not. Incidently, this dialogue mechanism, with Congress, with society, with the central bank is extremely important. They get to know what we're doing in terms of fiscal policy, of aggregate demand, and so on.

We also have some targets related to the debt dynamics. In particular, the Law applies to all levels of governments, not only at the national level, but also subnational levels, i.e., states and municipalities. And that's very important, because during the '80s, states have accumulated such a big debt that at some point we had to refinance this debt. But at the moment we refinanced, we also established a fiscal program, with targets for the debt.

So, one important aspect of the Fiscal Responsibility Law, together with some measures taken by the Senate under this framework, is to establish a path, a convergence path for those states that have debt above the ceiling established under the umbrella of the law.

States are by and large free to decide how to follow the convergence path, although the Law also provides ceilings for expenditure with personnel and special provisions if one is above the ceiling. You have penalties stating what a State or municipality can or cannot get when in fault. For instance, they cannot borrow and in some cases they cannot get voluntary transfers from the government. Also, states above their ceilings have to reduce the excess expenditure on personnel. This is important because in many countries, emerging poorer countries, personnel, is a very large ticket in public expenditure.

Very rapidly to give the overall reach of the law: we also have something that has proved extremely important—and we could discuss it later—which is a restriction on tax expenditures. That's very important. It has proved to be a wonderful protection against rent-seeking of all sorts. If you want to give a subsidy to any operation, to the private sector or to the public sector, you have to have a specific law. You have to show from where the money will come—what kind of offsetting you are prepared to take, either cutting out expenditures or increasing revenues. So this together with very stringent requirements in terms of publication of results that cover all levels of government contribute to a lot of transparency in the fiscal arena. This has proved very useful.

Just a final word about the Law. One interesting lesson we have learned has been what kind of penalties are really effective. We have learned that, say, institutional rather than judicial penances are the most effective. It is when you confront a state with the fact that it cannot borrow because either the state has too much debt or is not complying with the rules from the Law, that the penaces are really effective. That's much more effective than, say, threatening one to go to prison or to pay a fine, because, as in any country, these other things take time to go to court, and the people, in a way or another, can be shielded. On the other hand, the political pressure of saying you're not getting something that's important to your place because you have been sloppy in some area, this proves extremely effective and can be also a strong weapon for good governance. The government can use this weapon when addressing, for instance, legislative houses that want to increase expenditures. Raising expenditure can be unconstitutional because if the requirements of the law are not fulfilled. You can make people accountable: you can do as you wish, but there are consequences.

So I think the fact that the law covers all these aspects provides a very good framework, and actually for municipalities, it provides even an additional value. This is more or less equivalent to the service provided by that framework of the financial programming. Those who are from the Fund will remember how it would often give to public officials a broad picture of the situation and the options available. The Law, through the different accounting statements its provide for, has made available a very good planning tool. People can test if their government plan, their objectives are feasible or not. Financial programming allows one to see in advance if the whole fits together. That's a very important tool for, say, people who are running for office for the first time and so need to learn in advance rather than in the middle of their term what is feasible, what is not feasible. An interesting thing that we have discovered often is that those experienced politicians, those who have already held office, let's say, ten years ago, often run into more trouble than the new ones, because some of them thought they knew how to run things because they had run before. It sometimes take time for them to realize how the situation is so different from the past, with the new transparency and control. I should stop here. I just provided a general description of the Law. I believe the effectiveness of the law in the last four years is unquestionable now.

MR. CARSTENS: Thank you very much, Joaquim, for this very comprehensive explanation of the experience in Brazil. As a matter of fact, we in the Fund are very pleased about the success of Brazil in its fiscal management. And even the markets are very happy. I just recently heard a report of Paulo Leme. He is friendly with Brazil in his comments most of the time; he said that now we have seen a paradigm shift in Brazil in terms of fiscal policy management. So it's widely recognized, your success.

Now I will invite Mr. Misra to give us his points of view, please.

MR. MISRA: Thank you, Mr. Carstens.

Let me first congratulate Mr. Kopits on his effort, and it's absolutely timely because the Fund has also been interested about developments in this particular area. Fiscal policy along with monetary and exchange rate and trade policies aim ultimately at employment generation and growth, along with financial stability, including control over inflation. They encompass a broad set of taxes and expenditures and debt management policies, but fiscal rules generally center around two important issues: how large the public debt and fiscal deficit should be, and how fast should the deficit be monetized through financing from central banks.

Large fiscal deficits have a number of adverse consequences, as we know, can lead to inflation, and as already the '97 crisis also showed us, all the impact that it can have.

Let me go straightaway to India, and we need to—when we find about the situation today, obtaining today, we need to know what happened historically.

Today, what we are facing in India is a huge budget deficit resulting in a high level of national debt. The fiscal deficit of the central government is 4.4 percent, and once you add the subnationals, last year it was 8.8, which is very high. The government debt is now close to about 75 percent, though I must say that both on the deficit front or debt front, India is not the only country. There are even many developed nations which are in the same arena.

Now, that there should be rules, there is no gainsaying that there should be rules, and the question is: Should they be rigid? Should they be flexible? Obviously, once you talk of an act or rules, too much flexibility would not do. At the same time, if it is very rigid, it doesn't allow countries to use automatic stabilizers in a counter-cyclical way to maintain the growth performance. And this is precisely what has happened in Germany and France, that when they tried to be controlled by the EU, they found it difficult. Again, the Fund itself has been advocating fiscal stimulus as an automatic stabilizer, and similarly we find the U.S. deficit. One can defend from their point of view as long as it's not a long-term phenomenon, as long as it can be corrected in the medium run.

So, therefore, the rules have to be there, but obviously it's only on occasions that you can flout the rules that to under certain conditions. And the exceptions— hard lessons can only be exceptions and not a matter of routine.

Let me go back to what happens in India and why we came to this kind of situation. We have a Constitution which was made in 1950, and that was, let me call it, an amalgam of the U.S. Constitution and the British, which is unwritten Constitution. Again, like the U.S., ours is a large country, like Brazil, so we have subnational governments. But in the Constitution, the subnational governments are sovereign in many ways. And there is a division of power which in case the central government wants to undo, it has to not only have two-thirds of the majority in the parliament, but it also has to have the majority of more than 50 percent of states agreeing to it. So, therefore, amendments to undo some of these powers or dilute some of the powers of the state government is much more difficult, particularly when we have multi-party systems and for the last 20-odd years or maybe 30 years, lots of coalition governments that have been coming up in the subnational government. And when we come to the central government, many of these multi-party varieties support the central government, so too much of strictness also withdraws—allows them to withdraw support. So I mention this primarily because there is a constitutional aspect to it that the states must feel that we are independent within our own fora. At the same time, there is a political aspect to it that in case the central government forces issues, then it is possible it will not be central government, that the government is to fall immediately . And this is one aspect that we have been specifying, though I would not give too much stress on it, that it is both in the country's interest and the Fund's interest that a particular government must run for a particular length of time to be able to pursue reforms.

Then we have arising from that a federal set-up with a well-defined division of tax system and expenditure powers between the central and the state. For the non-plan expenditure, that is, more or less for the staff expenditures and upgraticism expenditures, there is a finance commission under the Constitution which gives states proposals once in five years, and the next five years are determined how the fund devolution from the central to the state. States' borrowing powers are restricted externally. No state can borrow abroad. But internally, inside, they can come to the central government, and with the central government's permission, they can borrow.

Now, this has led to a lot of problems on our front. External financing is limited to only bilateral and multilateral assistance, and the Indian Government has never raised market loans abroad. In fact, that is one of the reasons we did not get into the '90s crisis, though we got into a crisis much before that for the same reasons as our deficits, on the same grounds.

It's very interesting why the political aspect is important, that from 1950 until mid-'80s, all of you must have heard of a term called Hindu rate of growth, which is 3, 3.5 percent, the country was growing at 3, 3.5 percent. But the deficits were always under controllable limits. There was never any problem until 1985. There are two reasons behind it. One is that until the 1970s there was only one party who linked both the central government and the state government, and these were people who were obviously responsible. So, it also tried to segregate that how independence or lack of it of the central bank would not—in our kind of situation would not be too relevant, even though our central bank is fairly independent by now. Because the leaders were responsible, therefore, there was no pressure on the central bank not to follow their policies. So until 1985, there was no problem.

Suddenly, after 1985, India started huge internal debt and also external borrowings, and that's when in 1990 the first Iraq war happened and the oil prices rose, there was this crash and we had to come to the IMF in 1991. At that time the accomadism went out of control, attenuating monetary policy considerarisms, creating inflationary pressures. During that period financial markets were repressed because of high fiscal deficits. The predominant concern of the government was how to finance the fiscal deficit so it tap the funds of banks through statutory preemptions at predetermined and low and fixed interest rates. As a result, about 35 percent of the funds of the banks went directly to the government bonds. Interest rates in the rest of the economy were also fixed, and because of preemption the banks had to cross-subsidize by charging high interest rates to the corporate sector. So this is what happened just before our economic problems and when we came to the Fund for assistance.

Post-1990, along with other reforms, obviously this was—this came to—the country could absorb that the central bank had a much more hands-off effort of central bank, five to six years of intervention, obviously created more problems, so gradually the central bank became more and more independent, and the government did not interfere, which was—it formally never interfered, but informally it was interfering, but that also stopped. So obviously the question that arises is that when you want to control your deficits, the institutions have to grow to a level where they can avoid the political consideration to some extent.

Now we have reached a stage where the fisc is acting as a dominant constraint in the reform process. In spite of all that, we have grown 8.8 percent. It is in this background that the strong political commitment came all over that we must have a fiscal responsibility and budget management act.

Now, interestingly, this act was introduced in the parliament about four years back, but it took them three years—it went to the parliamentary committes. It took them three years to be able to decide whether we should have legislation like this.

Now, they took advantage of the Brazilian law, I think either the draft law or the law had already come, and they looked at other countries where it was—New Zealand and other countries. But at the same time, they decided that if the law is too strict, it cannot be amended, it's possible that they would not be able to proceed with growth and development in spite of deficit. So they decided after three years, which was a long time, let us have a more flexible law, but they suggested at the same time the rules must be more strict, the rules under the law, because then you don't have to come back for amendment to the parliament every time. That is why the very peculiar legislation, that the legislation itself is five pages and the rules are 12 pages, much longer than the act itself. But there are certain essential golden rules such as balanced revenue over debt requirement, non-monetarism budgets. These have become the core of the legislation. The plan is that—the prognosis is that the revenue deficit will be eliminated by March 2009 at 0.7 percent a year. From 2006, 2007, the government cannot directly borrow from the central bank except through ways and means advances within limits set by the parliament.

Now, some of the other important provisions of the act, inter-generaser liquidity, long-term macroeconomic stability, revenue surplus, removing impediments in the effective conduct of monetary policy, prudential debt management through limits on debt and deficit, enhanced transparency with the government having to go to the parliament once in three months with a statement that have they conformed to the act or they have violated; if they have violated, why.

The rules have set annual targets of phased reduction in key deficit indicators over the period. The rules also impose annual ceilings on government guarantees and additional liabilities. At the same time, obviously this wouldn't succeeded if the tax revenue—the ratio to GDP doesn't increase. Today it is a very, very low 9.9. So they're looking at 11 percent by 2008, 2009. The issue now is that the central government has laid a particular target for itself, which is 4.4 percent today, and they expect it will be zero by 2009. But the subnational governments are not totally under the control of the central government for amending their own legislation. And as I told you at the beginning, when you want to dilute their powers, then you need the consent of more than 50 percent of states, and in the political set-up I don't see why the states will readily agree to curtailing their own powers.

Now, certain issues which are of importance that we must look at today. For example, this year the 4.4 percent is again supposed to come down to 0.7, and this government—and my Minister was here and when he met with the MD, he said that we are determined to bring it down. But what has happened, the increase in oil imports in India has been 7.8 percent, even though the Fund documents talks of 10 percent, 7.8 percent, but the oil bill has increased by 50 percent. So I don't know how much they can do. They're trying their best. All that I can say is that these are exogenous factors that, in spite of an act or rules, may arise.

Then I will talk of certain issues that may come up. I need to clarify that the state governments, many of them responsible—I am saying many of them responsible, have also come up with a fiscal responsibility management act in their own states. But many of them were not responsible in the management of their own affairs, are still not doing it, and they are adding to the deficit in their own states, except that now the central government has said that without my permission you cannot borrow even internally. So we believe that in two to three years' time, the realize note would come in all the states that they need to be much more disciplined.

The transparency of guarantees, again, the state governments under the Constitution could give guarantees beyond that by the three limits that have been foreclosed. Two or three things that have come up in a paper that has been written by two of our colleagues in the Fund. One is the penalty that if you do not—if you transgress, what is the penalty? Why would anyone bother about it? They have suggested the U.S. model, that Congress determining what would be the budget—I mean, what is the final budget limit, so, therefore, what can be the deficit. Firstly, in India it's not possible because, as I told you in the beginning, it is a combination of the British and the U.S. system, so Judiciary is totally separate. But the parliament—the Prime Minister and the Ministers are the majority party, so they're the executive, but the majority party in the parliament, so obviously once as an executive they have decided I must flout my law, so there is no way that parliament can actually control them. Whereas, here Congress may belong to a different party—it normally does—and they have a scope for telling the President, okay, I'll approve this expenditure and not approve the other expenditure. So, therefore, an outside body to approve budgetary process doesn't seem to be very feasible. There has to be internal discipline and the growth of institutions like more and more independence of the central bank, which is already there. But looking at the observance of the problems that arise out of the budgetary deficits and the realization that has come in both the body politic as well as in the financial sector, I do believe that we are on the growth path and we will be improving every year, and I do believe that in 2009 we should be on a zero deficit scenario.

Thank you.

MR. CARSTENS: Thank you very much, Mr. Misra, for this very detailed and interesting description of the experience of India.

Now I invite Mr. Usman to present his views, please.

MR. USMAN: Thank you, Mr. Chairman. Let me join Mr. Misra and others in congratulating George Kopits for a very good and, of course, incisive book. I think it covers seriously issues which are bothering not only emerging markets but even countries that for some reason depend significantly on external support for their budgets. Budget discipline certainly is important, and it's gradually being understood even by the ordinary man on the street that elected representatives have a responsibility to manage the resources and to provide services that the ordinary man expects to get from government. So it is important that we underline the use of rules-based fiscal policy in not only emerging markets but I think in all economies.

As has been pointed out, this was a recent development. I think it started in the '90s with the realization that there is a need to put down some rules to guide those who manage the resources of a country. It's been gradually, I think, accepted, and I think it is in spite of political differences and political pressure in many countries, been recognized that there is some merit in some kind of basic rules to follow to manage resources.

My experience, of course, will be based on Nigeria's experience, and I would like to give a little background in the Nigerian case. Nigeria attained independence in 1960 from British rule. Prior to that, of course, things were based on the British system, the British budgetary system and parliamentary system. Things were working. I recall in my young days, those days when we used to undergo some courses in the institutes where we almost recite by heart the rules for budgetary implementation, and budgets were, at those times, I think, regarded highly and implemented religiously. You cannot go over budget, you cannot spend more than has been allocated you. And even at times central governments or the municipal governments or state governments used to have limits, and they had what they called mandatory reserves, where a certain percentage was reserved to be saved or not spent even though the whole budget has been approved, but that percentage will not be spent. And people followed it and things, I think, worked well.

Unfortunately, in the mid-'60s, the military came in, and since the first military coup in 1966, things have changed significantly. In the military, of course, it's a unitary government. From the top to bottom, they give orders. You have to obey commands, and like military men, of course, they don't listen. They just give instructions or commands, and you have to follow. And they have no respect for rules or regulations, so you just have to do what they wanted.

One of the merits, of course, even at the time before things got out of hand, was the fact that as a military government, while you have a central government, you have the state governments, and you have the municipalities, but still orders come from the top right down, and you have to follow. They appoint the governors. They even appoint chairmen of municipalities. That's okay. At least there is some kind of control over what people do or don't do. But gradually, as times, as you know, elapsed, the military became too used to power. I think they say power corrupts and absolute power corrupts absolutely, and, of course, they got used to power. They thought they could do whatever they liked. They had no respect for budget. They spent anyhow, they borrowed anyhow. And we got ourselves into some very nasty situation.

The current Constitution guarantees that the central government, the states, and the municipalities will share revenues that are collected. Revenues are collected centrally at the federal level, other than local revenues, of course. States have their own local revenues they can collect. Local municipalities have their own revenues they collect. But largely revenues are collected by the central government, and there is a formula for distribution or sharing. The central government takes some percentage, state government some percentage, and local governments take some percentage.

Once that distribution takes place, there is little or no control, on what the states and the municipalities do, by the central government, other than perhaps some issues of policy which were inherited from instructions under military which were passed right down. Right now with the state and with the municipalities, they regard themselves as independent, you know, the governors and the chairmen regard themselves as chief executives, and they manage their budgets the way they like and nobody challenges them. This I think has led to profligate spending without due accountability.

This has led to serious misuse or abuse, you know, of the budgetary process, and, of course, serious indiscipline.

There had also been, I think, three attempts since the first militarycoup to amend the Constitution because since the first set of military rulers, they had thrown away the Constitution and since there was no Constitution and then they could do whatever they liked. But each time they considered the military would end their rule, the first was around '79 or say'77-78, there was a review of the Constitution which was in place before they came in, and they changed quite a number of things, including the formula for distributing revenues, including, of course, the way elections could be conducted, including several other things that affected the conduct of policy.

That particular Constitution worked. Initially we had a democracy that worked for the first time in four years, and then there was another election. But only three months after that second election, the military unfortunately came back and they had another stint of another nine years or so of military rule. Before they left, also, they organized another review,, you know, where some group of people reviewed the Constitution again in line with what they thought perhaps the people wanted. So these successive reviews—there was another review also in '99, just before the current democratic dispensation came in, these successive reviews certainly have changed a number of things. And they have brought, in the process, some new things which introduced almost complete independence to the various levels of government. Right now the central government has little or no control over the state or the municipalities, and this has created serious problems.

Management of the economy has become much more difficult because there is no consolidated government account that reflects both the municipalities and the states into the federal account. There has not been control of the spending of the two other tiers of government. Of course, they have been limited, as far as the foreign borrowing is concerned. There is limited power for states and municipalities to borrow, but they can do that subject to the approval or guarantee of the central government. In most cases, central governments are reluctant to guarantee, but, of course, under a democracy, you are cajoled, you are compelled. Of course you will be accused that because the ruling party at the other tier of government does not belong to the ruling party at the center, you are undermining, you know, their chances to access resources to help the people. So in some respects I think the central government itself is almost being compelled, you know, to guarantee loans particularly from multilateral sources, from the World Bank, from other institutions. Otherwise, they have limits as to borrowing from abroad. But locally, of course, they have no limit. So where the revenues that are collected centrally and distributed are inadequate or where they decide, you know, to be profligate, they spend as much as they can spend. And this puts a lot of liquidity into the system. It puts a lot of pressure on both the interest rate and the exchange rate, and overall economic management, therefore, becomes extremely difficult.

The Nigerian authorities have undertaken programs with the Fund. These were in most cases, of course, largely stand-by arrangements. They never accessed the resources, but, of course, they undertook the programs. A couple of years back, the authorities became embarrassed that, you know, all undertakings under programs had not been successfully met. They had given undertakings, they had not been able to meet, you know, the undertakings for a number of reasons. And they decided to sort of jettison the program they were in at that particular point in time, and they had to come up with some kind of a reform program, you know, after taking stock of their own situation. They had to come up with some kind of a homegrown program which they thought they could undertake.

But under a democracy, of course, it is very difficult, I think, to sell reform programs; not only associated with the IMF, but even a homegrown program gets extremely difficult to put in place.

The last four years have been difficult. The ruling party has tried its best to put in place a framework that could work and that could provide opportunity for the economy to grow and for the growing poverty that has since the recession and the downturn in the global economy and in the economy of the country, became pervasive. I think it has been difficult to come up with such a program. The ruling party itself was divided. The politicians, of course, most of the politicians, this time, didn't know anything about democracy. They had been under military rule for some 30 years, some 30-odd years. So most of them were young, and became of age, you know, during military rule, so they have seen the way the military had acted and had not acted, when they thought that they had absolute power. Now that these are politicians, they have the matters of state in their hands, it has not been easy. Certainly this has led to the realization generally that there must be some rules. And there is need, I think, to organize and manage the economy in such a way that you adopt best practices and you address issues that concern the people rather than concern those in power or in politics.

So some progress has been made. Some significant efforts have been made to, you know, reconstitute institutions and to address constraints, technical and administrative constraints, and also to put in place the rules that will guide the conduct of the business of government.

In that respect, the government decided, I think after studying, and in collaboration with the Fund staff, the various fiscal rules elsewhere, to come up with a draft bill, fiscal rule or fiscal responsibility bill which had been submitted to parliament last year, although it was a little premature then. They had not quite done their homework, and they had not mobilized the necessary political support for it. They later on had to withdraw it from parliament and to try to mobilize the necessary support.

We have 36 state governments in Nigeria, and we have about 700 municipalities, and you need to mobilize the support of these at the barest political base to be able to get something through in the parliament. So they had withdrawn the bill. They are currently consulting between the various tiers of government, trying to mobilize some support. They intend to send it back to parliament, I understand, before the end of this year, and hopefully it will be sometime next year before there will be a discussion on it in parliament. Probably it would be approved. And once it's approved and given that they are now undertaking a homegrown program which is being monitored by Fund staff, that will take them some way in getting their acts together in order perhaps to discuss with donors and with creditors to address their debt.

Budget balance, of course, is one of the things they will address, but their main concern right now I think is the public debt, which is considered heavy by Nigerian standard, and perhaps to be able to obtain some significant debt relief from the international community, they need to put some program in place. Selling an IMF program is very much a sensitive issue, and their own homegrown program has to work and has to prove useful and prove successful for them to be able to obtain debt relief. But certainly their main concern under the fiscal responsibility bill is how to address public debt and how to bring matters into real control.

Part of the problem they have in Nigeria is that it is an economy that is largely dependent on a single commodity, oil, which is a non-renewable resource and has very volatile conduct. The flow of resources, therefore, is volatile. Sometimes you have some windfalls. Sometimes, of course, it falls. I remember in 1997, '98, the oil price fell to around $12 per barrel, and it has made conduct of business of government extremely difficult. We had a similar experience in the mid-'80s when oil price went up to $40, and then around '81 or so it collapsed and it was around $8 per barrel. And you can see how much volatility there is in government resources and how difficult it would be to manage resources.

So when resources are available, they go on a spending spree. When resources are low, of course, they resort to the banking system. And the central bank certainly has been in serious difficulties to control government excesses. And central bank independence is another issue, I think, which is important and which has to be recognized under such rules-based systems.

I believe that putting rules in place and obeying rules is important, but mobilizing the necessary political support is even more important, and the realization that at all levels of government there is need for some kind of discipline, not only at the central government but also at the state and municipal governments. And a great deal of, I think, enlightenment, public enlightenment and education is very important.

Broader acceptance of international best practice and calls for more accountability and transparency in a democracy compel governments, of course, to accept the need for rules and for budgets to be managed not only at the central government level but also at other levels. And I believe this cooperation is what is taking place right now in Nigeria, and there is a significant transformation taking place between the various levels of government.

I would like to stop here. Thank you, Mr. Chairman.

MR. CARSTENS: Thank you very much, Ismaila, for this very clear presentation of Nigeria and addressing different issues that are of interest to the Fund, like precisely how does this fit in the relation with the Fund, and highlighting the specific problems of an oil-producing country.

So last but certainly not least in this case, I give the floor to George for him to give us his presentation.

MR. KOPITS: Thank you very much Agustin for the kind words, and thanks to all who are here, colleagues, friends from many years I spent in the Fund.

I will refrain from reciting all the names of authors and facilitators, but would like to mention that this book is the product of a collective effort, involving not only individuals but also institutions. In particular, the Secretariat of Finance of Mexico played host to the Oaxaca conference and the World Bank and the Fund provided logistical support.

Instead of attempting to summarize the volume, I would like to take this opportunity, if I may, to share some thoughts from the vantage point of my present "incarnation", that is, mainly from the perspective of monetary policy, with primary focus on Central and Eastern Europe, many of them new EU member countries on the way to the euro.

Let me begin with a few words about the context of monetary policymaking in emerging markets in general. As I found out over the last ten months or so, emerging market economies, including those in Central and Eastern Europe are continuously exposed to the strong ebb and flow of external capital movements. All of a sudden the market gets bullish, and investors rush into these countries, and then with equal vigor, they may leave just as abruptly. Meanwhile, domestic credit markets in these countries are rather shallow, as we all know. In these circumstances, it is particularly challenging to finance large budget deficits while trying to disinflate towards a specified inflation target and eventually approach a broadly defined measure of price stability. Sizable government financing requirements and a rising public debt-to-GDP ratio imply that monetary policy must be conducted under a high degree of fiscal dominance.

Why is this a problem? For one, of course, the intertemporal budget constraint somehow will have to be met, either through high inflation, or alternatively, by adopting a tight monetary stance. More immediately, large budget deficits contribute to high domestic demand, which eventually is felt in inflation pressures. In addition, the fiscal imbalance can be reflected in a wide current account deficit, as we experience in Hungary, given a rather low propensity to save in the private sector.

Putting it all together: monetary policy faces a difficult balancing act in emerging markets. Interestingly however, under the umbrella of EU membership, even before membership actually took place, but once the markets factored this into their expectations, sovereign risk became negligible on foreign currency-denominated borrowing in Central Europe. But the currency risk premium, incorporated in high interest rates on domestic currency borrowing, remains considerable in new EU member countries with large government financing needs, as in Hungary.

Nevertheless, we must draw a distinction between two groups of new Central and Eastern European EU members: one group comprised of smaller countries, namely, the Baltics and Slovenia, where the fiscal accounts are close to balance. In the case of Estonia, in fact, we can see a small budget surplus and a very low debt-to-GDP ratio. These countries can be said to be on a credible path of convergence to the reference values of Maastricht. Moreover, just a couple of months ago three of these countries—Estonia, Lithuania, and Slovenia—have formally started to operate within the corridor of the ERM2 exchange rate regime. The prospects look good for these countries to join the euro area by the year 2007.

The other group includes larger Central European countries—Poland, the Czech Republic, Hungary—where budget deficits have been around 6 percent of GDP and the public debt-to-GDP ratio is in some cases close to 60 percent of GDP. These countries are experiencing a situation of fiscal stress, partly attributable to the fiscal effects of EU accession [see G. Kopits and I. Szekely, "Fiscal Policy Challenges of EU Accession for the Baltics and Central Europe" in G. Tumpel-Gugerell and P. Mooslechner, Structural Challenges for Europe, Edward Elgar, 2003, pp. 277-97]. In a steady state situation, these effects are estimated to average 3 percent or more of GDP yearly, largely because of the additional expenditures in connection with EU membership dues and matching of transfers from EU structural funds, or in compliance with EU standards. In addition, on the tax side, especially countries that have relatively high tax rates, we can see the effects of tax arbitrage. For example, Hungary is already experiencing some revenue erosion from a 25 percent value-added tax rate, as compared to neighboring EU members with nearly 10 percentage points lower VAT rates. I believe this gap exceeds VAT rate differentials among states in Brazil.

[Inaudible comment.]

MR. KOPITS: Be that as it may, the challenge ahead for major Central European EU member countries is to proceed on the path of convergence to the fiscal reference values, set in the Stability and Growth Pact (see H. Berger, G. Kopits and I. Szekely, "Fiscal Indulgence in Central Europe: Loss of the External Anchor?" IMF Working Paper WP/04/62, April 2004). The pact is altogether applicable to old and new EU members alike, except that euro members are subject in principle to financial sanctions upon violating the deficit limit of 3 percent of GDP. And beyond the pact, new EU members will be required to comply strictly with all the Maastricht criteria in order to enter the euro area. In contrast to the Baltics plus Slovenia, the earliest date for the major countries would be about 2009, 2010.

And in the meantime, to ease the fiscal stress, and to give way to monetary dominance, these countries need to implement structural reforms, reforms which have not been yet completed under the transition from socialist central planning. The demographic deterioration, the aging of the population is an additional burden that needs to be faced in these countries. So the task ahead is very large, especially if we keep in mind that it involves meeting both the macroeconomic criteria under Maastricht and all the microeconomic (mainly regulatory) requirements of EU accession, including those that facilitate access to EU budgetary resources..

Arguably, it can be said that EU accession has been good news, but to an extent bad news as well, for these countries. But, whether the news is good or bad is partly in the eyes of the beholder. On the one hand, the umbrella of EU accession is good in that it provides some protection and stability to the new member. On the other, it is not all that beneficial if this translates into a false sense of security and greater latitude for fiscal indulgence in the member country.

The real good news is that EU membership entails importation of rules-based macroeconomic discipline as well as of a proven institutional infrastructure. Although not all the 80,000 pages of regulation, of course, are useful, but a good many of the regulations and the 31 chapters of accession have contributed to progress in the new members. In contrast, non-EU emerging market economies need to develop their own institutions and best practices from scratch.

However, broadly speaking, there is a central political economy challenge that cannot be readily addressed with EU membership or with the fiscal rules embodied in the Stability and Growth Pact. This is the challenge of creating a culture of stability in the political elite and in the population of each country. While this culture of macroeconomic stability is by now well established for example in Estonia, it has not yet taken hold in Hungary or Poland. Elsewhere, Brazil stands out as an encouraging example, where an increasing number of politicians, be they from the right or from the left, abide by the constraints of the Fiscal Responsibility Law. In other emerging market economies, including India and Nigeria, such legislation has yet to be broadly supported by the electorate. As my friend Vijay Kelkar put it, quoting an Indian saying, "you cannot steal an elephant by night". At an extreme, the recent Argentine experience illustrates the difficulty of attempting to impose fiscal rules in the midst of a crisis. By the same token, a key test of a fiscal responsibility legislation is whether it can survive at least one political cycle, marked by elections. It can be said that Brazil has successfully passed this test.

What can the new EU member countries really do, besides simply aiming to meet the Maastricht fiscal criteria? Certainly if they comply with Maastricht, it's fine. But the problem is that the government deficit and debt limits requires compliance with the bottom line, affected by a lot of different exogenous and endogenous factors that impact the fiscal bloc. Therefore, given the constraint of tax competition, Central European members should introduce their own internal rules limiting the growth of primary (noninterest) expenditures or its most important components (preferably on wages and transfers) well within the broader envelope of the convergence path to the Maastricht limits. Several Northern European EU members already have such internal expenditure limits; similarly, the Brazilian legislation sets binding caps on personnel and pension outlays for each level of government. Furthermore, to ensure that such limits are not procyclical, expenditure growth can be tied to the trend GDP growth rate.

MR. CARSTENS: George, thank you very much for giving us a tour about the main content of your book and for relating some of the experiences of Eastern European countries.

After these very rich four presentations, now the floor is open for questions and comments. We might have 15 to 20 minutes. Yes, please?

QUESTION: I had a question. I'm Sandy McKenzie from the Research Department, and I was formally George's deputy about 12 years ago or so, I think. I had a question about his analysis of the budgetary disarray in Nigeria, I guess. If I understood him correctly, basically you blame the legacy of military dictatorships. But reprehensible though they may be, some military governments can be fiscally responsible. I think Chile's government past a certain point was. And I wondered if there wasn't even a more basic problem in Nigeria, which you alluded to, one, the dependence on oil and the corruption that that seems to entail; secondly, the lack of a middle class; and then, third, the lack of owned financing sources for the states, which really forces the national government, the federal government to do and finance all their expenditure so that it has, in effect, responsibility without real power.

MR. CARSTENS: Thank you. Let's see if there are more questions, and then we'll take them all, and then give you the floor. Yes, please?

QUESTION: This is a question for Mr. Kopits. From your perspective, which is the—can you comment on the role of the central bank when the government is not too disciplined by fiscal roles?

MR. CARSTENS: Thank you. Here, then there, and then here. Yes, please?

QUESTION: Thank you. There was a lot of discussion about preconditions, what I would call preconditions for successful introduction of fiscal rules. And there's certainly a danger in—and I completely agree that that's very important, that society is there. But let me be a bit provocative and ask: Can you ever see a situation where it's worth taking the risk and pressing the envelope and going ahead of where maybe the political class is or the society is with a tougher rule than maybe people are ready for? And also the issue of transparency, which I know is relevant, but people didn't talk about it too much. Mexico and Brazil have had tremendous improvements in that respect, in fiscal transparency. And how important is it that that element be there before we introduce rules? And as some of us who have thought about it or been there, we know there's quite a bit of flexibility one can employ with accounting, fiscal accounting. And we see the case of Greece just recently, tremendous revisions to the fiscal deficit ratio.

Could I ask a little bit about transparency as a precondition?

MR. CARSTENS: Yes, please? And why don't you identify yourselves.

QUESTION: I'm particularly interested in knowing a little bit more about the experience of the accession countries in relation to the type of rule that tried to get to work against the natural instability of our economies, like, for example, the balance over the cycle or what Chile has adopted, the structural budget surplus. Could you please comment about the discussion and experiences in accession countries?

MR. CARSTENS: Please.

QUESTION: Yes, thank you. I'm a guest here. I chair a coalition of NGOs and academics called New Rules for Global Finance, and we're working with UN Financing for Development Office on the systemic issues, consultations for the UN in the lead-up to the high-level dialogue next fall. I have questions—I'm a political scientist by training, and I'm concerned about the opening remarks of Mr. Carstens on wouldn't it be great if central banks were not only independent of politics but also fiscal policy were somehow independent of politics, and it relates to the other gentleman's question of, well, if the society isn't right, maybe we should just go ahead. And I guess I have a concern for democratic principles and the role of the fiscal budget in promoting growth and reducing poverty.

And then another question is what vehicles or what policies you would see as addressing countercyclical problems. I'm assuming you're supporting—no one addressed this—opposed to—or you support capital account liberalization. I mean, how do you address the boom-bust and the cyclical policies, you know, if you're mainly concerned about stanching the flow of spending? That's what it sounded like.

MR. CARSTENS: Thank you very much. Yes?

QUESTION: Yes, I am Sheila Williams. I'm a visitor here from the Eastern Caribbean Central Bank. I'd just like to ask Mr. Usman whether any consideration was given to setting up an oil reserve fund such that during times of high oil prices when you have a boom, you set aside some for when oil prices fall. Thank you.

MR. CARSTENS: Okay. Thank you very much. Yes, please?

QUESTION: I had question more on the enforcement of the rules itself. Given that often rules are necessary when fiscal discipline is not in order, if you could talk a little bit more about what kind of fiscal incentives or penalties you can impose, especially in a situation where you have, quote-unquote, sovereign local governments and the political pressures are very high.

MR. CARSTENS: Thank you. Yes, please?

QUESTION: I would like to ask George how he sees the development in Poland with respect to the constitutional fiscal rule in Poland, because Poland is probably the only accession country which has a constitutional limit on public debt.

Now, if we look into the history of how it worked and whether it actually brought up a new generation of politicians with a new view and understanding of the importance of fiscal rules, I'm not so sure, because what's happened is that, on the way when they reach the first kind of triggering level—because it's not only an absolute limit, but there are triggering levels requiring actions on the way to reach 60 percent. First, surprise, surprise, the GDP was revised by 10 percent, shaving off 5 percentage points of the debt issue. Then when they hit the first limit, they changed the rule which set the ratio between deficit and expenditure. So all of a sudden, part of the expenditure disappeared from the central government budget. Then when they are getting closer to the second triggering level, which is kind of even more binding—and it's very serious because you have to actually have a debt issue in T-plus two years, which is below the year you crossed the level. So it's a very tough rule, especially if you have a high deficit when you hit it.

Now they are talking about introducing ESA(?) 95, definition of general government, which will shave off another six, seven percentage points of the debt. So actually to me the bottom line is—and that's probably my underlying question to George—if there is fiscal—if there is political will to be disciplined, fiscal rules are very useful because they can put a framework on this, they can give you all the necessary signals, all the necessary kind of ways of doing this. But if there is no political will, then even a constitutional debt limit may not work or may not work in the way it is supposed to. I'm not even referring to the SGP and any study around that. I think this case is even more clear because that was their sovereign will to have in their own Constitution [inaudible].

MR. CARSTENS: Okay. Thank you very much. So let's give the answers to all these questions, and let's try to do it in the next 12 to 15 minutes. So let's start in inverse order, and let's give the floor first to George. And then we'll go to the rest of the speakers, and I'll address at the end the question that was directed to me by the lady.

MR. KOPITS: Well, I'll try to bring some of these together, these questions in my response. What can monetary policy do if the government is not disciplined, whether rules-based or not rules-based, it's not disciplined, and you're facing large budget deficits? The truth is that monetary policy can do very, very little if there is no fiscal discipline. I mean, to compensate, there could be chicken games. You can have non-cooperative—you can depict this with non-cooperative games with, of course, a suboptimal outcome. Needless to say, where you might still have some degree of price stability or disinflation, but at some cost in terms of—a not insignificant cost in terms of growth, output loss. So that's—it is a situation that cannot be solved simply by a tough monetary policy. Indeed, it's absolutely essential that government, through fiscal policy, plays a cooperative role in the disinflation process by containing aggregate demand or the growth of domestic demand in any case.

There was talk here about the whole issue of democracy, and I don't mean to take away any of the points that you are going to make, Agustin, but, yes, there are proposals and some academicians have put forth proposals of having an independent fiscal authority, much like the central bank in the case of monetary policy. Frankly, personally I think this is a non-starter. You have a principal agent problem. You would have this fiscal authority without really an instrument, maybe the independence but not the instrument. And certainly you have some question raised about what sort of relationship can exist between the principal and the agent.

On the other hand, I don't believe that fiscal rules necessarily go against any democratic principles. What we are talking about is really depoliticizing—or that's the effort with the rule, depoliticizing the aggregate performance of fiscal policy. You still should have—and you can have, I'm sure in Brazil you have a continuous debate and dialogue and political haggling, or whatever you want to call it, in election time or between elections as to whether you should have more resources allocated to education or to guns or roads. And that should be where most of that political discourse and where the political actions should take place, and not so much on the size of the debt or the deficit.

Obviously, reasonable people can disagree. I mean, you know, there are macroeconomists who tend to disagree with each other, as you all know, so it's...

On transparency, it's crucial. As the last question clearly indicated in the case of Poland, if you don't have transparency—and nowadays, I mean, with the technology and communications, with the media, with a more informed media, let's face it, many of our colleagues, instead of coming to the Fund after leaving school, they go off and they work for these financial analyst groups and investment banks and so forth. So many who are observing Poland know about these creative accounting exercises, and then that takes me to the other part of the question on the political will.

Obviously, if there is no political will, it's just not going to work. There is a whole chapter on political will versus rules, I think, in the volume. And there are many examples for this. Without political will, no rules are useful. But then, again, the question is, well, if you have the political will, why do you need the rules? You do need the rules, and not only in the fiscal area but also in the monetary area, particularly in the case of emerging markets that have to establish a reputation. The establishment of political credibility—or of policy credibility and reputation is part of the emerging market process, and it's almost inherent in the process. And it's very easy to lose this credibility, as some of the Central European countries have experienced in the last year or so, not only in the fiscal area but also in the monetary area. So then, again, we come back, well, the rules are convenient, a commitment, a technology device for this purpose.

The question about structural balance, of course, the structural balance is what should be aimed at, but it's very difficult to do it if your back is against the wall and you are in a tough financing situation to convince the markets, hey, I'm running a deficit, but it's—or an increased deficit — [tape ends].

— Estonia. Estonia has a currency board arrangement. In addition to that, it has also not a constitutional but just policy guideline type of balanced budget rule, tight budget balance rule, but with a stabilization fund to help it cushion an exogenous shock, as they did in the mid-'90s with the Russian crisis. They had huge budget deficits, and right now they have surpluses.

Brazil is going in that direction, which is useful. Chile has already gained that credibility in the marketplace. They can do it as well. Notice they have relatively low debt also, debt-to-GDP ratio.

I think I have answered all the—or tried to answer, anyway, all the questions.

MR. CARSTENS: Thank you, George, for this great effort to answer everything in a very short period of time.

Now, Mr. Usman, please.

MR. USMAN: Thank you, Mr. Chairman.

The question was asked whether or not oil is part of or mainly the problem, but also the issue of corruption and absence of middle class and lack of other sources of revenue by other tiers of government. Certainly oil has a lot to do with it. The fact that by its very nature oil revenue in inflationary, you put in very little in terms of effort, of course, you get a lot of revenue. If it is used properly, probably it helps. If it is not used properly, it creates serious problems. And I think that was the problem of Nigeria.

The fact that oil revenue was flowing and was flowing in large numbers, and of course, coupled with that, you have the military government where there is significant use of discretion and arbitrariness, throwing away the rules and the laws, this created the environment whereby corruption could easily persist. If you are arbitrary in the way you conduct business of government and you use a lot of discretion, certainly corruption breeds.

Middle class in Nigeria survived over the years, feeding on rent-seeking and, of course, on connections and concessions. And with the gradual opening up of the economy and perhaps the removal of such subsidies and rent-seeking, the middle class, of course, disappeared. Part of the disappearance or the reason for disappearance of the middle class also is in discipline in budgetary practices. Both at the central level and state and municipal level, people access because of their connections and contacts, you know, huge government contracts, governments exceed their limits and, you know, overstretch themselves in terms of commitment, starting huge projects, some of them white elephant projects, some of them projects which they cannot completely execute, and people get themselves—get their hands burned. And they cannot be paid because the resources are not there. And when there is a change of administration, the new administration also starts new projects, and they ignore old commitments. So I think this largely killed the middle class.

Source of revenue for the other tiers of government, certainly they have other sources of revenue, but, of course, when free money comes, you tend to be complacent and you tend to sort of stultify people's initiative. The state governments and the municipal governments have other sources of revenue. They can collect water—from providing services of municipalities, water bills are not being produced, and water rates are not being collected. Road taxes are not being collected. Market dues are not being collected. Land and property taxes are not being collected. So these are the kinds of things which, if the oil revenue is not there, of course, states and municipalities would have to collect these for them to conduct their business. But when they receive free money every month, that is a medium of what they call the federation account where the revenues collected at the central level are distributed, and each tier of government, you know, walks away with a check. So why should you bother to collect other revenues. And this is I think what is happening.

Of course, when the oil price goes down, then everybody gets worried. When it goes up, everybody wants to spend whatever is there.

And this brings me to the question of whether there is an oil fund. No, there isn't a formal oil fund as such. But there had been a provision—in fact, through the several negotiations Nigeria has had with the Paris Club, for instance, there has always been a provision in the Paris Club agreement that whenever oil goes above a certain level, you use 50 percent or 50 cents of every increasing dollar to repay debt, and the remaining 50 percent you save in terms of increasing your reserve. But there is no formal rule of managing that reserve which you build up. So when the situation is bad, of course, they dip their hands in it. When it is good, they try to build it up. But since you distribute a significant part of it, you are now only talking of the central government's portion or share of that windfall. The rest goes to the other tiers, and they have no rules and they just spend them as they come in. So that is, I think, the problem.

Lack of institutions or at least the weakness of institutions also contributes because when the police or the customs or any other parts of the institutions are not working, when the judicial system itself is not working, you have no way of achieving what under normal circumstances would be best practice elsewhere. The customs duties, customs officers should collect more revenue than they do, but they are not collecting because a lot of smuggling is taking place. The police collude with the customs and immigration to do all sorts of things. You go to the courts, it takes quite a long time to prosecute a case. And banks that lend find themselves unable to collect their debts because they have no way of enforcing their mortgage obligations.

So these are the kinds of things I think that have happened, and unless you can really build the institutions, unless, of course, you can bring in such rules and regulations, that is I think where the fiscal rules—fiscal responsibility rules come in. That is perhaps the beginning. But you also have to look at the other aspects, the institutional arrangement to make sure that it works to help implement and institute the fiscal rules.

Thank you, Mr. Chairman.

MR. CARSTENS: Thank you very much.

Mr. Misra?

MR. MISRA: In fact, I have educated myself on many of the things that happened all over the globe. But I had a small question to ask my colleague, Mr. Levy, if he doesn't mind. He said that the discipline is so strict that now you can't go to the World Bank for aid if there is deficit. But I do recall in the Fund Board, the Brazilian ED or other, in fact is your governments' policy to be advocating that structural loans to be given by the World Bank for development of infrastructure, both in the private sector—I mean, not private sector but public-private partnerships should be outside the budget and should be, you know, extra-budgetary. So that has been one of the major arguments of the Brazilians. In fact, they has asked us to support that also. So I was a little confused whether that is correct.

MR. CARSTENS: Before he takes that up, let me just clarify the question that was directed to me, and I will give the final word to Joaquim.

When I mentioned the fact that an appropriate institutional infrastructure has been created in monetary policy by central bank autonomy, and that it would be advisable to make similar progress in terms of institutionalizing fiscal policy, I did not mean to suggest to make the Ministry of Finance autonomous. To build the institutional infrastructure in the fiscal area, rules need to be created to reflect the social consensus that contained discretion is an appropriate way to condition fiscal policy in the future, in recognition of the value of fiscal discipline at the society level. This can take different forms, either by constitutional amendment, guidelines or some commitments, without these implying an autonomous Ministry of Finance.

Now, you close the discussion.

MR. LEVY: Okay. Just for the record, I would also echo some of the things that Agustin said, in particular in relation to questions about democracy, transparency. Yes, I believe that transparency in accounts are essential to have rules that are effective; otherwise, the whole thing becomes a mockery and you're just stepping back.

I believe that just taking the example of Brazil, it's interesting because they were talking about hijacking the power of either the government or Congress. It's interesting because on one side you can have, for instance, very high earmarking, which makes the legislative process actually weaker because there is not much to be decided. On the other hand, what our fiscal responsibility law establishes is that you have to have clear targets. But these targets are decided by Congress, actually decided every year with a horizon of three years. So it's not that, say, some exogenous entity, you establish the target and the limit. You have in the law some expanding limits, but otherwise actually something that increases the responsibility and accountability of the legislative process. You put very clear guideposts for this process, and if you change them, you just have to explain why.

Actually, in our idea of central bank independence, we actually don't call it independence. We call it autonomy, exactly because of that. You have, let's say, the political body saying what should be, for instance, the target, the inflation target. This can be done by law. Now it's done by a body that brings most of the ministries that respond to the President, so indirectly elected officials. And they establish the inflation target, and then the autonomy of the central bank is that if you set a target for someone, you have to give then the means so they have the freedom to achieve the target. But I think with that and with the transparency, we do preserve and actually we do strengthen the democratic process.

The same thing with enforcement. Of course, the fiscal responsibility law works well in Brazil because the previous government and this government before it was elected had a very clear commitment with the full settlement of contracts. For instance, one of the—and it goes in many guises. The law itself established that they cannot refinance other tiers of government, so they have to find their ways of adjustment. I cannot give and have largesse with other levels of government. That's fundamental. I also have the debt contracts with them, and I cannot break them, and the law doesn't allow me to renew them, refinance them. If you don't believe in contracts, all of this is useless. But if you believe and you want to enforce contracts, that's very powerful. And in the same way, any time you're limiting the increasing debt, you are basically creating institutional constraints on slippage in the flows.

Now, specifically on the question about the World Bank and so on, of course, the states can borrow if they satisfy a number of rules. Now, what we've been discussing with the Fund actually in this framework of the pilot project—and this is the context in which this discussion of the Bank appeared—I think there are a few strands of the discussion there. One is that to the extent that this discussion has been motivated for very good reasons by the World Bank, by multilaterals, we thought that together with higher accountability to these institutions, we could think about special treatment. We have a long-standing discussion with the World Bank, for instance, about the kind of credit they can extend and whether they are consistent with, say, the macro environment. It's sometimes no good just to peddle new loans if these are not consistent. This is an ongoing discussion with the Bank.

On the other hand, I think one interesting thing that—I mean the interesting thing in this whole debate is that you may in some cases have, say, investments that have a very high fiscal return, not social return, not just economic return, but fiscal return. I mean, you put some money and you can see that this money comes back in taxes, whatever, a free flow. If it's tied with other things, it doesn't satisfy.

Well, in these cases, this intuition of the whole discussion that, well, in some cases it's worth to postpone a little bit or to stretch a little bit the repayment of a debt might be worth it because you have something that is so much—the return is so much higher than your cost of funds. Well, maybe this might deserve special treatment, a treatment that has to be transparent. It's not the way you're going to compute under the primary or whatever, but to just say, well, this may justify a second look. And this is a bit—now, if the multilaterals want to participate in that, that's good. I mean, they have a first-rate group of economists. They ought to be, especially in consultation with the Fund, able to assess if something is consistent or is not consistent with the macro framework. And in these circumstances, I think we could work out a system where they would have, say, some special treatment or given some sort of preference, whatever, would be the thing. That you could do, and I think just increase their accountability too, which is good.

That will be all. Thanks.

MR. CARSTENS: Well, thank you very much, Joaquim. Thank you very much to all the panelists, and thank you for your participation. And as a final word, we formally recognize and congratulate George for his job which is materialized in this book, and we wish the best of success for it. Hopefully it will be broadly sold because it's a very rich book.

Thank you very much to all of you.

[Applause.]