Speech

Speech by Rodrigo de Rato
Managing Director of the International Monetary Fund
Manila, Philippines, July 31, 2007

As Prepared for Delivery

1. Let me begin by thanking Mr. Del Rosario for his welcoming remarks and Mr. Sy for that very generous introduction. It is a pleasure to be here in the Philippines and see firsthand the progress that you have made. Things have changed a great deal since Michel Camdessus visited the Philippines as Managing Director of the Fund in 1994. Our relationship with your government is now that of a "friendly advisor," and we also look to the Philippines as a source of advice and inspiration for other emerging economies.

2. I would like to share with you the International Monetary Fund's latest thinking on the state of the global economy and especially on recent developments and prospects for Asia and the Philippines. I will also discuss some risks to the global economy, some challenges posed by globalization, and some policy responses that can help governments to contain these risks and meet these challenges.

3. We are now in the fifth year of a strong global economic expansion. Last week, the Fund updated its World Economic Outlook, and we now project that growth in 2007 will exceed 5 percent, which is higher than we thought just a few months ago. One striking development this year is a shift in the sources of growth. In 2006, the United States was the main engine of growth, accounting for almost a quarter of global growth. We do not expect this to be the case this year. Growth in the United States will fall to about 2 percent. Even at this lower growth rate, because of the size of its economy, the United States remains very important: it will account for about 15 percent of global growth. But for the first time, the largest contribution to global growth will now be made by China. Also, the euro area countries, which have been benefiting from structural reforms, will make a contribution about equal to that of the United States.

4. Looking ahead, we expect to see this pattern of growth to continue. We expect the U.S. economy to regain momentum gradually as the drag from the current housing correction and softness in the business sector dissipates. Prospects in Europe and in Japan remain good. And we expect China and-increasingly-India to continue to grow in importance as engines of global growth. We believe that growth in China is likely to be over 11 percent and growth in India around 9 percent in 2007, and we project that growth in both countries will be almost as high again next year. Other economies in emerging Asia are showing similar strength. We expect the Philippines to grow at rates close to 6 percent in 2007 and 2008, and growth in the ASEAN-5 together-Indonesia, Malaysia, the Philippines, Thailand, and Vietnam-to average about the same in each year. Inflation is projected to remain low in most Asian countries, including the Philippines. External current account positions are likely to remain in substantial surplus. Net capital inflows are expected to continue.

5. To sum up, the outlook for the global economy is generally good, and the economic prospects of most countries in emerging Asia are also good, notwithstanding some adverse effects on the region from low growth in the United States. The questions then are, what are the risks to this good outlook, and what are the policies needed to contain these risks? I want to bring to your attention three aspects of the current situation where I think there are important risks. The first is the situation in the global oil market. The second is risks in financial markets, especially those affecting emerging markets. The third is the potential for a backlash against globalization. Let me take each in turn.

6. The market for oil is exceptionally tight. So far, the global economy has shrugged off high oil prices in part because the high prices are themselves largely the product of economic growth which has led to rising demand for oil. But there are also considerable vulnerabilities on the supply side, with respect to both production and refining, and a supply shock could be much more damaging to global growth. With regard to oil production, geopolitical concerns call into question the reliability of supply in some countries. In others, underinvestment has constrained capacity. In refining, uncertainties about long-term demand for gasoline in an industry where investments have only long-term payoffs have also led to persistent underinvestment, which is only gradually being reversed.

7. In the light of this market tightness, policies to curtail demand and improve energy efficiency become very important. There is consensus that governments should encourage energy efficiency. Last week, the U.S. National Petroleum Council joined calls for a rapid increase in vehicle fuel economy standards in the United States. And around the world, private companies are already adopting policies designed to conserve energy in the face of rising costs. Governments can also reduce subsidies and tax exemptions for energy, and replace them with targeted assistance to citizens most affected by high energy prices. This was done with considerable success by Indonesia last year. There is also an important example of a similar policy initiative in the Philippines, which I will return to in a few minutes. More generally, the danger posed by climate change underlines the importance of curtailing demand for energy products over the long term, either through higher carbon taxes or the introduction of a broad system of tradable emissions permits. And here in Asia, limiting the growth of energy consumption would not only be good for the environment but also for many energy importing countries' balance of payments.

8. Let me now turn to the risks stemming from financial globalization. The growth and dynamism of capital markets have contributed greatly to the prosperity of recent years. The combination of new technology and the development of new financial instruments has led to an upsurge in productivity in the financial sectors of many countries. The global economy has also become substantially more integrated, through financial globalization. This had many good effects. It has given global savers a wider pool of investments to choose from. It has given borrowers access to a much broader market for savings and so lowered their cost of capital. In some cases, it has encouraged development of local capital markets and financial sectors. And especially when flows have taken the form of foreign direct investment, it has accelerated technology transfer, improved productivity, and provided employment opportunities.

9. However, there are also risks associated with financial globalization, and I am concerned that these are still not fully appreciated. We have already seen this phenomenon play out in the sub-prime mortgage market in the United States. Both mortgage borrowers and investors in these markets appear to have been so confident that housing prices would continue rising that they ignored the consequences of a downturn and the attendant credit risks. These developments suggest a need to take a fresh look at lenders' underwriting standards and also to educate borrowers in the risks that they are taking. I also see grounds for concern in the recent dramatic growth in large private equity buyouts, which are being financed by a rising proportion of debt. If some of these deals were to turn sour, it could trigger a reappraisal of risk which would curtail market access more broadly. This in turn could adversely affect investment and growth prospects, not just in the countries where the problems occur but worldwide. I would urge regulators to remain vigilant about these deals, and pay especially close attention to deals whose failure could have systemic implications.

10. Another concern is potential instability from capital inflows. Capital inflows are in many ways a good thing. Asian emerging economies, including the Philippines, have been among the major beneficiaries from the lower capital costs, increased investment, and rapid technological transfer that I listed earlier among the benefits of financial globalization. But very substantial flows also complicate macroeconomic management and expose the countries that receive them to an abrupt reversal of flows when sudden shocks occur.

11. Emerging economies can best respond to such capital flows with a twofold response: sound macroeconomic management and financial sector deepening. The best macroeconomic policy response is to pursue exchange rate flexibility with limited intervention aimed at smoothing volatility in the exchange markets. In some cases, fiscal tightening is also appropriate. In addition to reducing inflationary pressures, this can reduce vulnerabilities by limiting debt accumulation. Improving the domestic financial sector framework is important because countries receiving capital inflows are least likely to experience instability if their financial infrastructures are strong. The Philippines authorities have already taken some useful steps. For example, they have been quite successful in encouraging banks to strengthen their balance sheets. Further development of the financial sector should be an important priority in the next few years.

12. The third area that I want to focus on today is the danger of a backlash against globalization in countries in many different positions. One of the paradoxes of recent global prosperity has been that while in many countries economic performance has been very good, people's satisfaction with that performance has not been so high. To some extent this may be attributable to the fact that the gains from economic growth, and more generally from changes associated with globalization, have been distributed quite unequally.

· In many advanced economies, GDP growth has proceeded at a rapid pace for the last several years, but median real incomes have not increased by nearly as much.

· In virtually all of the advanced economies, the share of income accruing to labor has declined over the last 25 years as a share of total national income.

· In many emerging economies, including in Asia, inequality has also increased. Over the last decade, inequality has increased in 13 out of 18 Asian countries for which data is available, including the Philippines.

· And in both emerging and developing economies, absolute poverty remains stubbornly high. The National Statistical Coordination Board estimated that 30 percent of people stilled lived in poverty in the Philippines in 2003.

13. These developments are leading people around the world to question the benefits of globalization. Some are tempted to yield to protectionist pressures and to give up on orthodox economic policies and structural reforms. I think it is important to resist both of these temptations. Trade has brought many more benefits than costs all around the world. And growth continues to hold out the greatest promise for lifting the poor out of poverty and providing better opportunities to the disadvantaged.

14. But we also need to make sure that the fruits of growth are widely shared and that the poorest people are protected from the costs of adjustment. Let me conclude by suggesting a few policies which can promote these good outcomes, some of which are already being put into practice here in the Philippines.

15. The first is an increase in investment in education and technology. Research from all around the world suggests that the main reason why inequality has increased in recent years is that the benefits of improved technology have accrued disproportionately to the richest countries and to the richest and best-educated people in all countries. The way to address this source of inequality is not to turn our backs on new technology but to widen access to it, and to education in technology. In the Philippines, building up telecommunications infrastructure and reducing the cost of international calls has stimulated growth in information and communications technology. As a result, employment in the sector-and access to its benefits-has increased massively over the last six years.

16. Development of other aspects of infrastructure can also be helpful. The lack of access of many poor people-especially in rural areas-to roads and electricity contributes to their isolation. I am pleased that President Arroyo emphasized development of physical infrastructure as well as human capital in her State of the Nation Address last week.

17. Financial sector development can help. Market failures and the absence of banking in rural areas adds to inequality. Addressing market failures and promoting microcredit would give the poor more opportunity to invest in themselves. Improving services to customers and financial education will also be important, as more people become consumers of financial products.

18. Finally, governments can take direct aim at inequality by replacing non-targeted tax exemptions and subsidies, for example for petroleum products and electricity, with targeted social assistance. Again, the Philippines provides an example. As you know, in November 2005, the Philippines government extended VAT to energy products previously exempted, and in January 2006 it raised the VAT rate on all taxable products, including energy, from 10 percent to 12 percent. Because most energy is consumed by wealthier people, and because the government used part of the proceeds from VAT reform to reduce excises on kerosene and to increase spending on infrastructure and social services, the effect on the poor was offset. The distributional effects could have been improved further if more of the compensation had been devoted to transfers targeted to poor villagers, such as those who benefit from the government's KALAHI program. But it remains a successful and impressive reform.

19. Let me conclude by returning to a point I made at the outset. The global economy is in a good condition. Governments can keep the global economy growing strongly by continuing good policies and by acting to contain key risks in energy and financial markets. They can also increase support for globalization and help their own poorest citizens by taking steps to address inequality. In several of these areas the Philippines is leading the way. The government and central bank have steadfastly pursued sound macroeconomic policies, and leaders in the Philippines are acting with imagination and innovation to improve the position of the Philippines' poorest citizens.

20. I am very pleased to have had the opportunity to talk to you today, and I now look forward to hearing your views and to answering your questions. Thank you very much.