1 IMF Surveillance—promoting Growth and Stability

International Monetary Fund
Published Date:
September 2004
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One of the core responsibilities of the International Monetary Fund is to maintain a dialogue with its member countries on the national and international consequences of their economic and financial policies. This process of monitoring and consultation, referred to as surveillance, is mandated under Article IV of the IMF’s Articles of Agreement and lies at the heart of the Fund’s efforts to prevent crises.

The IMF exercises this responsibility of surveillance in several ways (see Box 1.1). Highlights of its surveillance activities during financial year 2004 follow.

  • As part of the Fund’s surveillance of the global economy, the Executive Board conducted its twice yearly comprehensive assessments of the World Economic Outlook in August 2003 and March 2004. Against the background of prospects for a gradual—albeit moderate—global economic recovery, Directors in August 2003 called for macroeconomic policies to remain appropriately supportive and for reinvigorated structural reform efforts. By March, the nascent recovery had strengthened and broadened, and Directors agreed that the focus of policy efforts should be on medium-term measures that would underpin the sustainability of the recovery while rebuilding room for maneuver to respond to possible future shocks. In addition, they observed that managing the transition to a higher interest rate environment would be a key challenge.

  • Also in August 2003 and March 2004, the Board discussed developments in financial markets worldwide, based on Global Financial Stability Reports prepared by the staff. In August 2003, Directors noted that financial markets had remained resilient, notwithstanding continued lackluster economic growth, but expressed their concern about several downside risks, with a focus on the policy implications of these market developments. By March 2004, with the prospects for financial stability appearing brighter, Directors stressed, among other things, that relatively benign conditions in mature and emerging markets provided a window of opportunity to focus policy attention on several key structural reforms.

  • The Board completed 115 consultations with individual member countries as mandated under Article IV of its Articles of Agreement.

  • Executive Directors discussed regional developments on several occasions. In particular, they discussed euro area policies (September 2003), the adoption of the euro by central European members (February 2004), and developments and policies in the Central African Economic and Monetary Community (November 2003).

Country Surveillance

To conduct surveillance in accordance with Article IV, an IMF staff team visits each member country to meet government and central bank officials and collect and analyze economic and financial information. The consultations cover recent economic developments and the exchange rate, monetary, fiscal, and relevant structural policies the country is pursuing. The Executive Director for the member country usually participates as an observer. The team generally also meets with other groups—such as members of legislative bodies, trade unions, employer associations, academics, and financial market participants. The IMF staff team normally prepares a concluding statement, or memorandum, summarizing the findings and policy advice of the staff team and leaves this statement with the national authorities, who have the option of publishing it.

Box 1.1Forms of IMF Surveillance

With its nearly universal membership of 184 countries, the IMF serves as an international forum where members can monitor global, country, and regional economic developments. IMF surveillance takes three main forms:

  • Country (“Bilateral”) Surveillance. As mandated by Article IV, the Executive Board holds regular consultations with each member country on its economic and financial policies, and the international repercussions of these policies. Through these “Article IV” consultations, which are based on staff reports, the IMF aims to identify policy strengths and weaknesses, indicate potential vulnerabilities, and advise countries on appropriate and corrective policy actions. The IMF also conducts bilateral surveillance through the Financial Sector Assessment Program, or FSAP (see Section 2).

  • Global (“Multilateral”) Surveillance. The IMF’s Executive Board regularly reviews global economic and financial market developments. The reviews are based partly on the staff’s World Economic Outlook reports and the Global Financial Stability Reports, both of which are prepared twice a year. In addition, the Board holds more frequent informal discussions about world economic and financial market developments. Activities in mature and emerging financial markets are monitored continuously, including in a daily internal report prepared by the staff.

  • Regional Surveillance. To supplement country consultations, the IMF also examines policies pursued under regional arrangements. It holds regular discussions with such regional economic institutions as the European Commission, the European Central Bank, the Central African Economic and Monetary Community, the Eastern Caribbean Currency Union, and the West African Economic and Monetary Union.

The IMF also takes part in policy discussions of finance ministers, central bank governors, and other officials in a variety of groups, such as the Group of Seven major industrial countries, the Group of 24, and the Asia-Pacific Economic Cooperation Forum. (See also Section 6 on governance.)

On their return to headquarters, IMF staff members prepare a report describing the economic situation in the country and the nature of the policy discussions with the national authorities, and evaluating the country’s policies. The Executive Board then discusses the report. The views of the country’s authorities are conveyed to the Board by the country’s Executive Director. The views expressed by the Executive Directors during the meeting are summarized by the Chair (or Acting Chair) of the Board, and a written summing up is produced. Subject to the approval of the member country concerned, the full Article IV consultation report and a Public Information Notice (PIN), containing a summary of the Board discussion and background material, are released to the public. The country authorities may authorize release of a PIN even if they do not wish to release the full report. In FY2004, the Board conducted 115 Article IV consultations with member countries (see Table 1.1). All PINs and the Article IV reports that the authorities have agreed to release are published on the IMF website.

Table 1.1Article IV Consultations Completed in FY2004
CountryBoard DatePIN IssuedStaff Report Published
Afghanistan, Islamic Slate ofNovember 21, 2003December 22, 2003December 22, 2003
AlgeriaJanuary 14, 2004January 29, 2004February 10, 2004
AngolaJuly 25, 2003September 10, 2003September 10, 2003
Antigua and BarbudaOctober 24, 2003
AustraliaOctober 22, 2003October 29, 2003October 29, 2003
AustriaNovember 24, 2003November 26, 2003November 26, 2003
AzerbaijanMay 14, 2003June 4, 2003June 6, 2003
Bahamas TheJuly 2, 2003July 23, 2003July 23, 2003
BangladeshJune 20, 2003July 11, 2003July 11, 2003
BelgiumFebruary 13, 2004February 27, 2004February 27, 2004
BelizeMarch 24, 2004April 16, 2004April 16, 2004
BoliviaJuly 7, 2003August 20, 2003August 20, 2003
Bosnia and HerzegovinaFebruary 25, 2004March 5, 2004March 16, 2004
BotswanaMarch 24, 2004July 30, 2004July 30, 2004
Burkina FasoJune 11, 2003June 30, 2003June 30, 2003
BurundiJanuary 23, 2004February 10, 2004February 20, 2004
CanadaFebruary 18, 2004March 10, 2004March 10, 2004
Central African RepublicApril 2, 2004April 14, 2004June 10, 2004
ChadMarch 19, 2004April 29, 2004April 29, 2004
ChileAugust 18, 2003August 20, 2003September 26, 2003
ChinaOctober 31, 2003November 18, 2003
ComorosApril 30, 2004May 14, 2004
Congo, Republic ofJune 13, 2003June 30, 2003June 30, 2003
Côte d’IvoireMarch 31, 2004April 21, 2004
Czech RepublicAugust 22, 2003September 5, 2003January 9, 2004
DjiboutiJanuary 7, 2004March 19, 2004March 19, 2004
Dominican RepublicAugust 29, 2003October 14, 2003
El SalvadorJuly 18, 2003December 22, 2003
Equatorial GuineaNovember 12, 2003December 9, 2003December 9, 2003
EritreaMay 2, 2003July 1, 2003July 1, 2003
EstoniaOctober 22, 2003October 27, 2003October 27, 2003
FinlandOctobers, 2003October 17, 2003October 17, 2003
FranceOctober 5, 2003October 29, 2003October 29, 2003
GabonNovember 10, 2003November 20, 2003February 5, 2004
Gambia TheMarch 8, 2004May 18, 2004May 18, 2004
GeorgiaOctober 17, 2003November 7, 2003November 7, 2003
GermanyNovember 3, 2003November 6, 2003November 6, 2003
GhanaMay 9, 2003May 16, 2003May 21, 2003
GreeceMay 16, 2003June 11, 2003June 11, 2003
GuineaJuly 16, 2003August 14, 2003August 14, 2003
HondurasMay 5, 2003
Hong Kong SARMay 16, 2003May 30, 2003May 30, 2003
HungaryMay 2, 2003May 9, 2003May 9, 2003
IcelandAugust 22, 2003August 29, 2003August 29, 2003
IndiaJuly 15, 2003August 21, 2003
Iran, Islamic Republic ofAugust 25, 2003September 5, 2003September 5, 2003
IrelandJuly 30, 2003August 5, 2003August 6, 2003
IsraelApril 19, 2004April 29, 2004June 3, 2004
ItalyNovember 7, 2003November 13, 2003November 5, 2003
JamaicaJune 9, 2003March 23, 2004March 23, 2004
JapanAugust 20, 2003September 5, 2003September 5, 2003
JordanApril 2, 2004April 28, 2004May 4, 2004
KazakhstanMay 28, 2003June 17, 2003July 18, 2003
KenyaMay 2, 2003July 9, 2003July 9, 2003
KiribatiJune 16, 2003July 7, 2003
KoreaFebruary 20, 2004February 25, 2004February 25, 2004
KuwaitFebruary 9, 2004February 25, 2004July 12, 2004
LesothoJanuary 21, 2004February 5, 2004February 5, 2004
LibyaAugust 18, 2003October 23, 2003October 23, 2003
LithuaniaSeptember 5, 2003September 9, 2003September 11, 2003
LuxembourgApril 28, 2004May 4, 2004May 5, 2004
MalaysiaFebruary 9, 2004March 24, 2004
MaliDecember 15, 2003January 12, 2004January 12, 2004
MaltaAugust 18, 2003September 3, 2003September 3, 2003
Marshall IslandsJanuary 26, 2004February 13, 2004
MauritaniaJuly 18, 2003August 13, 2003October 10, 2003
MauritiusJune 30, 2003August 6, 2003October 14, 2003
MexicoOctober 15, 2003October 30, 2003
MoldovaJanuary 26, 2004February 2, 2004February 18, 2004
MozambiqueDecember 10, 2003December 22, 2003March 5, 2004
MyanmarMarch 17, 2004
NepalAugust 22, 2003September 5, 2003September 5, 2003
NetherlandsJuly 30, 2003August 8, 2003August 5, 2003
Netherlands AntillesJune 4, 2003June 13, 2003June 13, 2003
New ZealandApril 30, 2004May 5, 2004May 5, 2004
NorwayMarch 22, 2004March 31, 2004April 2, 2004
OmanOctober 6, 2003October 22, 2003
PalauFebruary 27, 2004March 2, 2004April 1, 2004
PanamaMarch 22, 2004March 26, 2004
Papua New GuineaJune 4, 2003June 25, 2003June 25, 2003
PeruFebruary 23, 2004May 28, 2004May 28, 2004
PhilippinesMarch 5, 2004March 30, 2004
PolandJune 9, 2003June 19, 2003June 25, 2003
PortugalMarch 15, 2004March 22, 2004March 22, 2004
Russian FederationMay 2, 2003May 9, 2003May 30, 2003
St. Kilts and NevisOctober 24, 2003November 4, 2003
SamoaJune 2, 2003June 30, 2003June 30, 2003
Sāo Tomé and PrincipeMarch 17, 2004April 2, 2004January 19, 2004
Saudi ArabiaOctober 10, 2003December 5, 2003
SeychellesFebruary 20, 2004
SingaporeMarch 15, 2004April 26, 2004April 26, 2004
Slovak RepublicJuly 23, 2003August 5, 2003August 5, 2003
South AfricaAugust 20, 2003July 1, 2004July 1, 2004
SpainMarch 19, 2004April 2, 2004April 2, 2004
Sri LankaMarch 5, 2004March 12, 2004March 16, 2004
SudanOctober 31, 2003December 19, 2003December 19, 2003
SurinameOctober 17, 2003November 19, 2003November 19, 2003
SwazilandFebruary 9, 2004May 25, 2004
SwedenJuly 25, 2003August 5, 2003August 5, 2003
SwitzerlandMay 23, 2003June 2, 2003June 2, 2003
Syrian Arab RepublicApril 30, 2004
ThailandAugust 25, 2003September 17, 2003
Timor-LesteJuly 14, 2003July 28, 2003July 28, 2003
TogoApril 28, 2004May 13, 2004
Trinidad and TobagoJune 23, 2003July 10, 2003August 4, 2003
TunisiaJuly 25, 2003August 7, 2003August 21, 2003
UkraineMay 14, 2003June 13, 2003June 19, 2003
United KingdomMarch 3, 2004March 5, 2004March 5, 2004
United StatesJuly 30, 2003August 5, 2003August 5, 2003
UruguayJuly 11, 2003August 4, 2003August 7, 2003
UzbekistanMay 19, 2003
VietnamOctober 3, 2003December 1, 2003December 5, 2003
Yemen, Republic ofDecember 22, 2003
ZambiaApril 7, 2004July 16, 2004July 21, 2004
ZimbabweJune 6, 2003July 28, 2003July 28, 2003

In addition, the Board assesses the economic conditions in, and policies of, member countries borrowing from the IMF in the context of its discussions on the lending arrangements that support the member countries’ economic programs. The Board also holds frequent informal meetings to monitor and discuss developments in individual countries.

Global Surveillance

The Executive Board’s conduct of global surveillance relies heavily on two staff reports—the World Economic Outlook and the Global Financial Stability Report—as well as on regular sessions on world economic and market developments.

World Economic Outlook

The Board’s twice-yearly reviews of the World Economic Outlook are an integral part of the Fund’s ongoing surveillance of economic developments and policies in its member countries and of the global economic system. These surveys of prospects and policies are the outcome of a comprehensive review of world economic developments and analyze short-term and medium-term prospects for the world economy as well as for individual countries and country groups. They draw for the most part on information gathered through the staff’s consultations with member countries and provide a framework for assessing the relationships among the economic policies of Fund members.

In FY2004, the Board discussed the World Economic Outlook on two occasions—in August 2003 and in March 2004. (See Box 1.2 for a chronology of key economic developments during FY2004.)

World Economic Outlook, August 2003

At the time of the August 2003 World Economic Outlook discussion, economic data in some countries and forward looking indicators, particularly in financial markets, pointed to a strengthening of global growth in the second half of 2003 and 2004, and Executive Directors noted the prospects for a gradual—albeit moderate—recovery.

Given this environment, Directors called for macroeconomic policies to remain appropriately supportive and for reinvigorated structural reform efforts to strengthen confidence and reduce vulnerabilities over the medium term. In particular, monetary policies in industrial countries should remain supportive for the time being, and—with inflationary pressures very moderate—Directors considered that most regions had scope for further monetary easing if the recovery faltered or inflation significantly undershot policy objectives. The orderly depreciation of the dollar was generally welcomed. Going forward, most Directors agreed that the cooperative approach, which would be needed to underpin the global adjustment process, would be helped by currency adjustments that were more broadly spread, with several emerging Asian economies being relatively well placed to handle greater upward exchange rate flexibility.

Directors agreed that fiscal policy would have much less room for maneuver. While automatic stabilizers should generally be allowed to operate, they stressed that greater priority would need to be given to credible, high-quality fiscal consolidation to address both the recent deterioration in the fiscal outlook of the largest economies and the impending pressures of population aging. Directors also called on industrial and emerging market economies to make sustained further progress in vigorously implementing ongoing structural reforms.

Directors underscored the particular importance of a successful outcome of the World Trade Organization (WTO) Cancun Ministerial meeting in September 2003 in curbing protectionist pressures and achieving further trade liberalization, which would help strengthen confidence in the economic recovery. Progress with agricultural reforms—especially in the largest industrial economies—would be critical for boosting the growth prospects of developing economies and making progress with poverty reduction. In this context, Directors expressed strong support for the initiatives being taken by the IMF and the World Bank to strengthen their support for developing countries’ efforts to liberalize their trade regimes.

World Economic Outlook, March 2004

The nascent recovery apparent in mid-2003 had begun to spread by the time of the Board’s second meeting on the World Economic Outlook. Directors welcomed the strengthening and broadening of the global economic recovery, noting especially rapid upturns in the United States and emerging Asia; a sharp pickup in industrial production and global trade; strengthened business and consumer confidence; and positive investment growth in most regions. A broad-based rally in financial markets, including a rise in equity prices, a further drop in bond spreads, and a rebound in private financing flows to emerging markets, supported the recovery. Although growth had picked up and oil and commodity prices had moved up, worldwide inflation remained subdued—a reflection of continued excess capacity, still-weak labor markets, and competitive pricing in both domestic and global markets.

Directors noted the significant upward revision to the global growth forecasts for 2004 and 2005, with the strength of the ongoing recovery pointing to upside risks in the short run. However, Directors also highlighted a number of downside risks. The terrorist attacks in Madrid of March 11, 2004, and developments in the Middle East were sobering reminders of the continuing geopolitical uncertainties under which the global outlook was being shaped. Although recent exchange rate adjustments had been helpful given the large global current account imbalances, most Directors cautioned that these imbalances would still remain large, thereby posing risks of potentially disorderly currency movements and increased protectionist pressures. Most Directors also pointed to possible increased market volatility and adverse consequences for private consumption in countries with buoyant housing markets that could result from an abrupt increase in interest rates from their currently very low levels.

Against the backdrop of the improved global outlook, Directors agreed that the focus of policy efforts should be on medium-term measures that would underpin the sustainability of the recovery while rebuilding room for maneuver to respond to possible future shocks. Managing the transition to a higher interest rate environment in most countries where growth was strengthening was a key challenge facing monetary policy in the period ahead. While the situation was likely to vary significantly among countries, depending on the evolving pace and nature of the recovery, Directors expected that, as the recovery continued, interest rates in most countries would need to rise toward more neutral levels. In this context, they considered it especially important that central banks communicate their policy intentions clearly to the financial markets to reduce the risk of abrupt changes in expectations, and that rate increases, when they actually occur, be well anchored on fundamentals.

To support an orderly resolution of the global imbalances in the context of sustained growth in the world economy, Directors called for the membership to adopt a credible and cooperative strategy that would facilitate the medium-term rebalancing of demand across countries and regions. The main pillars of this strategy should be a credible medium term fiscal consolidation effort in the United States; an acceleration of structural reforms in the euro area; further banking and corporate reforms in Japan; and a gradual shift toward more exchange rate flexibility, combined with additional structural reforms to support domestic demand, in most of emerging Asia. Reiterating the critical importance of open markets for supporting broad-based global economic growth and poverty reduction in low-income countries, Directors called for a timely resumption and successful conclusion of multilateral trade negotiations under the Doha Round.

Box 1.2Key Economic and Financial Developments, May 2003-April 2004

The global economic recovery gained traction during 2003, with growth nearly reaching its long-term trend rate (Figure 1.1). With accommodative policy stances in the industrial countries and renewed confidence beginning in the second quarter of 2003, economic growth strengthened and broadened. Growth in world trade volume also picked up, buttressed by increases in intraregional trade in Asia, involving especially China and Japan. Net private capital flows to emerging market and developing countries increased as portfolio investment rebounded, and foreign direct investment (FDI) also picked up. Emerging market bond spreads narrowed and many emerging market sovereigns took advantage of the low interest rates to issue debt.

Although the recovery became increasingly broad-based, its pace and nature varied significantly. During the financial year, growth was most rapid in the emerging market countries of Asia, particularly China, and the United States, and least well established in the euro area. The recoveries in the United States and Japan gained steam-spurred by the growth of private consumption and a rebound in business investment in the United States, and the growth of net exports, business investment, and consumption in Japan. More than in the corresponding stage of most previous cycles, employment growth in the United States was subdued during much of the financial year, turning up only toward the end.

The euro area showed some signs of recovery beginning in the second half of 2003, but growth remained well below its potential and domestic demand growth was lackluster. Cyclically induced job losses were less pronounced in the euro area, but the gradual recovery was insufficient for unemployment to fall from its nearly 9 percent rate.

In FY2004, the recovery broadened to include improved GDP growth in all emerging market regions. In many cases, the recoveries were export-led, but, gradually, the strengthening of domestic demand began to contribute to growth.

Growth improved in most countries of Latin America. There was a sharp rebound in economic activity in Argentina following its deepest recession in 20 years. Brazil’s growth picked up during the financial year, but in a number of other countries, notably Venezuela and Bolivia, political uncertainties continued to undermine growth. As of end-FY2004, economic activity, initially spurred by exports, was becoming more reliant on domestic demand.

Emerging Asia continued to experience the fastest growth, with those countries affected early in the financial year by the Severe Acute Respiratory Syndrome (SARS) epidemic rapidly recovering. The region accounted for about half of world output growth in 2003, demonstrating its importance as an engine of global expansion. China continued to grow strongly, exhibiting incipient signs of overheating toward the end of the financial year. India’s growth accelerated, reflecting both cyclical and structural factors.

Central and eastern Europe maintained relatively strong growth despite the sluggish performance of its largest trading partner, the euro area. In some countries, current account deficits widened as rapid credit growth and expansionary fiscal policies fueled imports. Net FDI inflows contributed less to growth than in the previous year, but, in most countries, the risks of a capital flow reversal were held in check. Higher global oil prices, as well as positive domestic factors, increased growth in the oil-exporting countries of the former Soviet Union. Oil importers in the region also experienced strong GDP growth on the back of robust domestic demand.

The Middle East also benefited from rising oil prices and increased oil production (including restored capacity in Iraq). Toward the end of FY2004, however, the intensification of hostilities in Iraq raised the prospect of renewed disruptions in oil supply.

Growth in Africa strengthened during FY2004, supported by improved macroeconomic policies, favorable weather, the abatement of conflicts, and debt relief under the HIPC (Heavily Indebted Poor Countries) Initiative. Higher oil and non-fuel-commodities prices also helped sustain higher growth rates in a number of exporting African countries.

With the firming recovery, producer and non-fuel-commodities prices rose. Oil prices surpassed levels seen before the Iraq war, owing to increased demand as well as to uncertainties about supply stemming from geopolitical risks. Consumer price inflation remained relatively subdued, in part reflecting substantial excess capacity and moderate wage increases. The dollar depreciated during the financial year on a trade-weighted basis. Toward the end of the financial year, however, the dollar steadied, and the euro fell back from its peak. Emerging Asian currencies also depreciated on a trade-weighted basis, accompanied by a further significant buildup in official reserves in countries with relatively inflexible exchange rate regimes.

Monetary policies remained accommodative in most countries, although in some cyclically advanced countries (including the United Kingdom) interest rates were raised, and, in others, policymakers were readying markets for such an event. Fiscal policies were varied. Looser fiscal policy in the United States helped to spur growth during much of the year, but the Stability and Growth Pact constrained the use of fiscal policy in some euro area countries.

In the major financial markets, nominal bond yields reached a four-decade low in the United States in mid-2003. Encouraged by abundant global liquidity, broadening economic growth, and the improving credit quality of both mature and emerging market borrowers, investors increasingly favored riskier assets. As a result, credit spreads on mature and emerging bond markets narrowed, and the cost of default protection fell. Toward the end of the financial year, as expectations of an upturn in policy rates in the United States gathered, market participants began to unwind carry trades and to reduce risk exposures.

Global equity markets rallied strongly on expectations of continued strong global growth and associated improvements in corporate earnings, as well as low interest rates (see Figure 1.2). The S&P 500 rose 45 percent from its March 2003 lows before retracing part of those gains as interest rate expectations changed near the end of the financial year. European equities followed a similar pattern, rising 50 percent from their mid-March 2003 trough before surrendering part of those gains by the end of the financial year. In Japan, stocks rallied almost 60 percent, as the growth of the Japanese economy strengthened, before falling back slightly, along with other mature market indices.

A rise in risk appetite and a search for yield fueled strong inflows into emerging markets. Driven by improving fundamentals and abundant liquidity, the spread on the EMBI+ fell precipitously from 756 basis points in late January 2003 to a near-record low of 384 basis points in early January 2004 (see Figure 1.3). Low nominal yields and strong investor demand facilitated increased bond issuance by emerging market borrowers, as many sought to lock in attractive financing costs by prefinancing their future funding requirements. Emerging market bond issuance in the primary market touched a record monthly high in January 2004 and totaled some $40 billion in January-April, covering more than half of the calendar year’s financing needs. Some 56 percent of total issuance during this period was from nonsovereign entities. Brazilian debt experienced one of its longest rallies in history, with continually narrowing spreads for 15 straight months. Similarly, having peaked at over 1,100 basis points in March 2003, the spread on Turkey’s EMBI+ sub-index fell by almost three-fourths in less than a year. However, by the end of the financial year, spreads on emerging market bonds had started to rise again as bond yields in the United States rose in anticipation of an increase in policy rates. Primary issuance of equities in emerging markets was also strong during the financial year, although investor appetite dimmed as the year came to a close.

Figure 1.1World Real GDP Growth and Trade Volume (Goods and Services)

Figure 1.2Equity Market Performance

(May 2003 = 100)

Figure 1.3Sovereign Spreads

(In basis points)

1J.P. Morgan Emerging Markets Bond Index Plus.

Directors emphasized that the relatively benign economic outlook provides an advantageous window of opportunity to address vulnerabilities. In particular, efforts to restore sustainable medium-term fiscal positions should be pursued vigorously. In most industrial countries, these will need to involve, in addition to timely fiscal consolidation, credible and high-quality measures to reform pension and health care systems. In addition, for emerging market and other developing countries the priority should be to address remaining public debt sustainability concerns through tax reforms to reduce revenue volatility, steps to strengthen fiscal institutions, and measures to improve the structure of debt.

Major Currency Areas

Directors welcomed the recent strong growth in the United States. With the impact of past fiscal and monetary stimulus gradually waning, they considered that the sustainability of the recovery would increasingly depend on continued solid investment and productivity growth and a pickup in employment, which had so far been lagging. In view of the weak labor market and low inflation, Directors supported the U.S. Federal Reserve’s decision to maintain a very accommodative monetary policy stance. In the future, Directors observed, the ground should continue to be laid for a move toward a more neutral monetary policy stance. While recognizing that the expansionary fiscal policy pursued by the U.S. authorities in recent years had supported U.S. growth and had had a positive impact on global output, Directors underscored that the priority henceforth would be sustained fiscal consolidation. On the basis of the IMF staff’s analysis of the global impact of U.S. fiscal policy, most Directors supported the conclusion that a more ambitious fiscal consolidation path than currently envisaged would produce significant benefits, in particular by containing the risk that higher real interest rates would crowd out productive investments. Accordingly, these Directors urged the U.S. authorities to establish a viable fiscal framework with the objective of returning the budget to balance (excluding Social Security) over the medium term and to undertake reforms to strengthen the financial position of Social Security and health care programs.

The recovery in the euro area remained subdued. While prospects for stronger domestic-led growth were being supported by an expected pickup in fixed investment, Directors saw the pass-through effects of euro appreciation, the ongoing balance sheet restructurings, and the Madrid bombings’ possible impact on confidence as factors that had the potential to dampen the outlook. In view of this fragile environment, Directors supported the continuation of the current monetary policy stance until convincing signs of a self-sustaining recovery in domestic demand emerged. Regarding fiscal policy, countries with weak budget positions should aim for a sustained adjustment of underlying imbalances, to achieve fiscal consolidation within the Stability and Growth Pact framework. Directors welcomed the recent progress on structural reforms, including the Agenda 2010 initiative in Germany and pension reforms in France. They considered, however, that to increase sustainable long-term growth and improve the euro area’s ability to adjust to shocks, more would need to be done. In particular, in anticipation of future demographic changes, Directors observed that product and labor markets should be strengthened further, and labor force participation and productivity growth increased.

In Japan, the strength of the recovery had continued to exceed expectations substantially, with welcome signs of a pickup in private consumption to complement exports and business investment as the main engines of growth. Deflationary pressures had also eased, and the authorities had made progress in strengthening the bank and corporate sectors. Directors encouraged the Japanese authorities to build on these achievements by making further strong efforts to sustain the recovery. In this context, they recommended continued quantitative monetary easing to bring a decisive end to deflation, adoption of a well-defined fiscal consolidation plan to tackle the very difficult budgetary situation, and further reforms of the financial and corporate sectors, particularly of smaller banks and enterprises.

Directors discussed the IMF staff’s analysis of the industrial countries’ experiences with structural reforms, which provided useful insights on how to move forward. While reforms had, in general, progressed fastest in areas that yielded the most immediate benefits, the experience over the past two decades showed that the end of a protracted period of slow growth provided a particularly favorable environment to embark on more difficult reforms. In such an environment, policymakers and voters remain aware of the costs of weak growth; at the same time, the economic recovery under way mitigates any short-term adjustment costs. Directors accordingly encouraged policymakers to take advantage of the recovery to press ahead with their structural reform agendas, including by carefully exploiting the complementarities between different reform areas.

Emerging Market and Other Developing Countries

Turning to emerging market and other developing countries, Directors welcomed the recovery, which had been aided by improved fundamentals, strong private capital inflows, and historically low spreads. GDP growth was expected to strengthen in most regions, although the outlook—particularly in countries where public debt remains high—could be affected by a deterioration in external financing conditions—for example, as a result of an abrupt or unexpected increase in interest rates. Directors acknowledged that, in addition to abundant liquidity in global financial markets, the decline in emerging market bond spreads also reflected the considerable progress being made by many countries in strengthening their fundamentals and improving the structure of their public debt.

The Board was encouraged by the improved outlook for Latin America, with stronger domestic demand beginning to contribute to an initially export-led recovery. To sustain the prospects for a further firming of the recovery, countries would need to continue making strong efforts to reduce their vulnerabilities to a possible deterioration in the global financial market environment and to further strengthen investor confidence. A number of countries in the region face a challenge in addressing pressing social needs against a backdrop of still high public debt levels. In this context, Directors stressed the importance of implementing broad-based reform strategies aimed at achieving strong and sustained growth. These strategies should be combined with well-targeted social programs and investments.

Directors highlighted the exceptionally strong growth in emerging Asia, which was underpinned by accommodative macroeconomic policies, growing domestic demand, competitive exchange rates, and the recovery in the information technology sector. Economic activity in the region was supported by buoyant growth in China. With growth accelerating and some financial imbalances emerging, many countries in the region would need to gradually tighten macroeconomic policies in 2004-05. In a number of countries, accelerated fiscal consolidation may be warranted, along with strengthened prudential oversight of the banking system to ensure that lenders appropriately evaluate and manage risks. Most Directors considered that timely, gradual steps by China toward greater exchange rate flexibility—combined with progress on developing the exchange markets and strengthening the banking sector—would contribute to price stability over the longer term by containing the continuous buildup of international reserves. Such steps would also facilitate similar moves by other countries in the region facing a need for monetary tightening and allow the region as a whole to contribute to more balanced growth globally. Directors discussed the implications of China’s rapid growth and integration for the global economy, and they noted that, while China itself clearly stands to gain the most from this process, the rest of the world will also continue to enjoy long-term benefits from China’s economic emergence, as already evidenced by dynamic productivity gains. To maximize these gains, Directors underscored the importance of continued further efforts by all countries to increase the flexibility of their economies to foster the mobility of resources among sectors.

The robust economic performance in most other emerging market countries was welcomed by the Board. Prospects for continued strong growth remain favorable across regions, provided timely actions continue to be taken to address vulnerabilities and further strengthen the foundations for private- sector-led growth. For many countries in central and eastern Europe, it was important to press ahead with fiscal consolidation efforts, in particular in those countries where a sharp widening in the current account deficit calls for firm action to reestablish budgetary discipline. In the Commonwealth of Independent States (CIS) countries, the priority should be to continue with reforms to improve the investment environment, strengthen banking systems and judicial frameworks, and dismantle intraregional trade barriers. Directors highlighted the importance of fiscal consolidation in most oil-exporting countries in the Middle East to reduce their vulnerability to oil price fluctuations. For the region as a whole, a more stable security situation and reduced geopolitical tensions will—along with employment-generating reforms—be key to accelerating medium-term growth.

Credit booms in emerging market economies, particularly the risk that such booms may presage sharp economic downturns and financial crises, were also examined by Directors. Credit booms are difficult to foresee, and authorities need to remain vigilant, especially in situations where rapid credit growth is accompanied by other signs of macroeconomic imbalance, such as current account deficits, investment booms, and increases in the relative prices of nontradables. Containment of credit booms usually requires strengthened surveillance of the banking system and close scrutiny of corporate borrowing during periods of rapid growth.

Directors were encouraged by the continued improvement in Africa’s economic performance, and the expectation that growth will accelerate further in the period ahead. A sustained further effort to accelerate growth and reach the Millennium Development Goal of halving poverty by 2015 remains nevertheless a pressing priority. This will require promoting stronger private sector activity and investment; reducing vulnerability to exogenous shocks; developing infrastructure; and strengthening institutions, governance, and transparency; as well as strong efforts to avoid the resurgence of civil conflicts. Directors welcomed recent regional initiatives to accelerate progress in these areas, including the African Peer Review Mechanism and the African Union’s adoption of a Convention on Preventing and Combating Corruption. They also emphasized that additional assistance from the international community would remain critical for Africa’s development and called for increased aid, continued debt relief, and—most important—greater access to industrial country markets.


Iraq was one of the founding members of the International Monetary Fund in 1946. Between 1980 and 2002, however, because of internal political developments, three wars, and international sanctions, the IMF had little official contact with the government of Iraq. With the fall of Saddam Hussein’s government in March 2003, the IMF reestablished contact with Iraqi officials working with the Iraqi Governing Council. A number of missions were fielded to Baghdad until the bombing of the UN compound in August 2003 led to the suspension of IMF travel to Iraq. The dialogue between the Fund and Iraq has since continued at locations outside Iraq. Fund staff have concentrated their work in two areas: (1) developing a macroeconomic framework and (2) providing technical assistance. In addition, the Fund’s Managing Director is represented on the International Advisory and Monitoring Board (IAMB), which was set up according to the directives of the UN Security Council to oversee the audits of the Development Fund for Iraq, the oil-export proceeds that go into the Development Fund, and the financial controls in place in the spending ministries.

Early work on the macroeconomic framework served as input into the initial needs assessment that was prepared for the donors conference in Madrid in October 2003. During this conference, which was attended by representatives from 73 countries and 20 international organizations, donors pledged some $33 billion in grants and loans in support of the reconstruction of Iraq in 2003-07. In April 2004, the Fund participated in a meeting at the U.S. State Department in Washington at which the core group of donors and institutions began preparations for the International Reconstruction Fund Facility for Iraq.

Fund staff worked on a debt sustainability analysis in consultation with Iraqi officials and representatives of the Coalition Provisional Authority (CPA). After contacting 50 countries that are not members of the Paris Club to get information about any outstanding loans to Iraq, the Fund estimated that debt to non-Paris Club creditors is probably about $60-$65 billion, compared with about $42 billion to Paris Club creditors and $15 billion to commercial creditors. This analysis was provided to the Paris Club in late May 2004 for their consideration of possible debt relief for Iraq. The G-8 summit in June declared that an agreement on debt relief based on the IMF’s work on the debt sustainability analysis should be reached by the end of 2004, after the G-8 and Paris Club members have consulted among themselves and with non-Paris Club creditors. On June 8, 2004, the UN Security Council endorsed the formation of the interim government of Iraq, which assumed power upon the dissolution of the CPA on June 28. The interim government is intended to serve until an elected transitional government takes office, which should happen by December 31, 2004, or, at the latest, January 31, 2005. The UN endorsement should pave the way for international recognition of the interim government and make possible the normalization of Iraq’s relations with the Fund.

The IMF has been a lead provider of technical assistance in Iraq since the summer of 2003. It has provided extensive technical assistance in a number of areas, including the introduction of a new currency, central bank and commercial bank legislation, the payments system, budget execution and public expenditure management, tax policy, revenue administration, and the compilation and dissemination of economic statistics. Training programs for Iraqi officials have also been provided in the macroeconomic, fiscal, monetary, and statistical areas.

Global Financial Stability Report

Another key tool for the IMF’s monitoring of global economic activity is the Global Financial Stability Report (GFSR), which, like the World Economic Outlook, is published twice a year. The GFSR focuses on the world’s financial markets, covering developments in both mature and emerging markets and analyzing topical structural issues relating to the global financial system. The report aims to identify potential fault lines in the global financial system, in an effort to help head off systemic crises. The Executive Board discussed two reports—one in August 2003 and another in March 2004.

Global Financial Stability Report, August 2003

At their August discussion, Directors noted that financial markets had remained resilient during the first half of 2003, notwithstanding continued lackluster economic growth, geopolitical uncertainties, and high market volatility. However, some concerns remained, associated with risks related to the macroeconomic outlook, rising long-term bond yields, the potential for weak corporate earnings, and the vulnerability of emerging bond markets to a correction.

Several policy implications of market developments were noted by Board members. They urged authorities in major financial centers to persist in reforms to shore up market foundations, including strengthening corporate governance to restore investor confidence; bolstering the regulation and supervision of insurance companies; and improving the accounting practices and regulation of defined-benefit pension funds.

Although the external financing climate for emerging market countries improved somewhat in 2003, Directors cautioned that public sector debt in these countries remained high and that there was no room for complacency by borrowers. They urged countries to take advantage of enhanced access to international capital markets to press ahead with the implementation of sound policies and improve the structure of their liabilities, including extending maturities and reducing the dependence on dollar linked debt. Directors noted that several countries had undertaken successful liability-management operations. They also welcomed the use of collective action clauses (CACs) in recent sovereign bond issues.

The discussion in the Global Financial Stability Report of the volatility of capital flows to emerging markets was welcomed by Board members, and they agreed that foreign direct investment should be encouraged. However, Directors pointed out that, while capital flows were inevitably somewhat volatile, sound economic policies and transparency could help countries make flows more stable. There was also much that emerging market countries could do to “self-insure” against the effects of volatility, including managing assets and liabilities; adapting exchange rate arrangements to the degree of capital account openness; strengthening domestic financial institutions; enhancing supervision and regulation; and developing local securities markets. Directors noted that developing efficient and stable local sources of finance had become all the more relevant since emerging markets as a group had become net exporters of capital in recent years. Directors also discussed the implications of increased holdings of international reserves by some countries.

Global Financial Stability Report, March 2004

Financial market conditions had strengthened by the time of the Executive Board’s GFSR discussion in March 2004, and the prospects for global financial stability appeared brighter. Directors noted that the improved outlook was supported by a firming of the global economic recovery, rising corporate earnings, and a strengthening of corporate balance sheets. Emerging market borrowers, many of which had taken steps to put their public finances on a sounder footing and improved the structure of their domestic and external debt, were benefiting from higher export demand and commodity prices.

Global Financial Market Surveillance

In response to this improved outlook and the exceptionally low short-term interest rates, Directors noted, global financial markets had staged a strong, broad-based rally in 2003. While low short-term interest rates were continuing to influence investor behavior and were, in some cases, encouraging increased risk taking in search for yield, most mature and emerging market indices appeared to be pointing to a period of consolidation, with investors showing renewed caution and increased discrimination.

The improved outlook for financial stability was not without risks, Directors emphasized, noting that risks would require vigilant monitoring, not least because of their interconnected nature. A first set of risks stemmed from the environment of prolonged low interest rates and abundant liquidity. In this environment, asset valuations may be pushed beyond levels justified by fundamental improvements, eventually necessitating a transition to higher interest rates in mature markets. Such an outcome may have broader ramifications, including increased bond market volatility if investors were to revise their interest rate outlook abruptly—as they did during the 1994 sell-off in global fixed-income markets—or if asset valuations that were predicated on an unusually low level of risk-free rates were corrected abruptly. To guard against these risks, Directors encouraged policymakers to develop timely and forward-looking communication strategies that encourage investors to base their decisions on fundamentals rather than on the expectation that interest rates will be kept indefinitely at very low levels. Directors noted that the potential effects of higher interest rates on emerging market economies were being mitigated owing to the progress that many of them have made in reducing vulnerabilities, while stronger world growth would also help offset the impact of higher interest rates.

The potential for market instability arising from large global external imbalances, including the possibility that adverse developments in the currency markets might spill over into other asset markets, was also discussed. The depreciation of the U.S. dollar against other major currencies had so far been orderly. Most Directors considered that, in view of the substantial capital flows that the U.S. economy will continue to need to attract, the risk of a pronounced currency depreciation—possibly resulting in higher U.S. dollar interest rates and a correction in asset valuations—can nevertheless not be dismissed. A strong and sustained cooperative effort—aimed at ensuring a smooth adjustment of global imbalances over the medium term—would remain a key policy priority for the international community.

Turning to the improved external financing environment for emerging market borrowers, Directors observed that the improved credit quality of many emerging market borrowers and low interest rates in the major financial centers contributed to the impressive compression of spreads on emerging market bonds in 2003. Directors commended many emerging markets for steps taken in the current favorable market environment to meet a substantial part of their borrowing needs, improve their debt structures, and extend maturities. The correction in 2004 of the downward exchange rate overshooting that occurred in 2003 in many Latin American economies was expected to enhance debt sustainability in these countries. Directors also welcomed the trend toward making the inclusion of collective action clauses in sovereign bond issues an industry standard. Notwithstanding the encouraging performance of the region as a whole, some countries appear to have relaxed their fiscal and structural reform efforts. Unless they take timely corrective action, Directors cautioned, these countries face a heightened risk of exposing their underlying vulnerabilities in the event of a turnaround in the current favorable external financing environment.

Board members welcomed the continued strengthening of the balance sheets of the household, corporate, and bank sectors over the course of 2003, as corporate and household sectors continued to build up liquidity, and rising asset values strengthened net worth. Nevertheless, rising interest rates may increase the debt service burden, particularly in a number of European countries where debt levels of the corporate sector remain high. Directors noted that the fall in long-term yields had increased refinancing activity in the U.S. mortgage market, reopening the possibility of hedging activity that might amplify yield movements. They welcomed, in this context, proposals to strengthen the regulation of the U.S. mortgage agencies and address the implicit government guarantee.

The relatively benign overall conditions in mature and emerging markets, Directors stressed, provided an advantageous window of opportunity to focus policy attention on several key structural reforms to underpin financial stability over the longer run. In mature markets, scandals in the mutual funds industry and some companies, such as Parmalat, again underscored the need to build on efforts to improve corporate governance and strengthen market foundations. In particular, Directors called for steps to strengthen scrutiny by investors and regulators of firms with complex ownership and capital structures, as well as to enhance public oversight of auditing practices. Priorities on emerging market countries’ agenda should include further reductions in the level and vulnerability of public debt, development of local capital markets, and continued strong efforts to improve the climate for foreign direct investment, which had remained at disappointingly low levels in spite of the general rebound in capital flows.

Risk Transfer and the Insurance Industry

The Board discussed a range of regulatory and disclosure issues raised by the transfer of risk from banking to non-banking institutions in mature markets, including the hedge fund industry, where, despite closer counterparty and investor monitoring, there appears to be a need for broader and more systematic transparency of exposures and practices. Directors noted that future staff work would focus on the hedge fund and pension fund industries.

Directors observed that the reallocation of credit risk to the insurance sector, together with improvements in risk management in the sector, appeared to have contributed to enhanced overall financial stability. Moreover, by allocating a greater share of their portfolio to credit instruments, many life insurers had availed themselves of a more predictable return. While the investment in credit instruments by insurers deserves to be supported, Directors stressed that this would need to go hand in hand with continued efforts to improve risk management and regulatory oversight of the sector. Recommended improvements include wider implementation of risk-based capital standards by regulators; enhancement of supervisory resources in many mature market jurisdictions; increased information sharing among supervisors; and strengthened disclosure requirements. Directors welcomed the current debate on international accounting standards for insurers and looked forward to the development of converging standards that provide an accurate reflection of insurance companies’ financial positions. Directors noted that disclosure should be comprehensive and include information on sensitivities and risks. While rating agencies play a helpful role in disseminating information on risks, Directors cautioned that they should not be a substitute for appropriate supervision.

Institutional Investors in Emerging Markets

As to the institutional investor base for claims on emerging markets, Directors saw the development of a stable investor base as a key element in reducing the volatility of capital flows to emerging markets. While ongoing changes have been contributing to a welcome broadening and diversification of the investor base, the decline in dedicated—relative to crossover—investors may also have increased the volatility of capital flows. Another source of potential volatility arises from the impact that even small changes in the portfolio positions of institutional investors can have on emerging markets, given the large size of the assets under the management of these investors. Directors agreed that the factors influencing the changing nature of the investor base as well as their policy implications—including for debt-management policies and practices in emerging markets—would require continued careful analysis. They emphasized the importance of adequate transparency and disclosure regarding both government policies and corporate developments, with investor relations programs being a particularly useful instrument. In addition, Directors noted that the development of an efficient market infrastructure in emerging economies would be helpful in attracting institutional investors from both mature and domestic markets.

Directors also commented on the supervisory and regulatory implications of the expanding portfolios of nonbank institutional investors in emerging markets, in particular the rapid growth of pension funds. In view of the growing imbalance between the assets under the management of these funds and the available securities, close coordination would be required between changes in the regulatory framework, the development of local capital markets, and the gradual easing of limits on foreign investment by pension funds to increase their opportunities for portfolio diversification. Directors viewed the development of local securities markets as key to ensuring proper risk management by the insurance industry. In view of the rapid growth and increasing sophistication of the activities of local institutional investors involved in both local and international markets, Directors observed that it would also be important to persevere with strong efforts to enhance the risk-management skills of both investors and regulators.

Regional Surveillance

Euro Area Policies

In September 2003, the Executive Board discussed euro area policies and the trade policies of the European Union (EU).

Euro area authorities faced many policy challenges, Directors noted. In particular, economic growth had come to a virtual standstill since the last quarter of 2002, with net exports and investment declining, and unemployment on the rise. Moreover, challenges loomed, with the aging of the population and slowing of labor force growth becoming an increasing drag on potential output growth, fiscal sustainability, and old-age income security. EU enlargement, while of benefit to all concerned, would also be a source of new challenges. Directors advised that meeting these challenges successfully would require a sustained shift toward more forward-looking national policies and the vigorous implementation of structural reforms. While adversity had begun to induce such forward-looking policies, notably on the structural side, the Board noted that it was essential that these potentially promising steps be sustained once difficulties recede.

Directors considered that the weakness of area-wide activity reflected a number of shocks as well as structural rigidities and policy lapses. The shocks included the bursting equity bubble, low business and consumer confidence, reduced external demand, the correction of the euro to longer-run equilibrium levels, and geopolitical uncertainties. Rigidities in labor markets and lesser reliance on market-based financing had, in some measure, contained the effects of the shocks, but they had also slowed both the post-bubble and intra-area adjustments. As a result, the area-wide stagnation was expected to be overcome only gradually, with growth remaining subpar well into 2004. Board members were encouraged, however, by improvements in survey and confidence indicators, which signaled a gradual pickup in growth during the second half of 2003. They saw the risks to the outlook as having become more balanced.

Despite the possible implications of the recent appreciation of the euro for the area’s short-term prospects, Directors viewed the appreciation as beneficial on balance, noting that it had helped curb inflation and that the competitiveness of the euro area was back to its long-term average. Most Directors agreed that the euro area had borne a disproportionately large share of the burden of adjustment to a weaker dollar and called for a more equitable global distribution of any further adjustment burden to reduce imbalances in the global economy and to achieve balanced growth in the major currency areas.

Monetary policy had done well and had established its credibility. It has been in line with inflation and output developments, and the monetary framework has been appropriately modified based on the experience of the past five years. In particular, the European Central Bank’s (ECB’s) clarification of its inflation objective as being “below but close to 2 percent” substantially reduced the scope for misinterpretation and provided a clear anchor for longer-run inflationary expectations. Most Directors noted that aiming for such inflation outcomes over the medium term provided scope for inflation differentials across member countries and a buffer against shocks that could lead to area-wide deflation. Directors also welcomed the clarification of the relative roles of long-term monetary analysis and short-term economic analysis in the ECB’s anti-inflation strategy.

Directors agreed that the ECB needed to guard against downside risks to inflation, noting that inflation pressures had subsided. While the downside risks had become somewhat more balanced with the pullback in the euro, the cumulative effects of weak activity, a continued softening of labor markets, and the significant past appreciation of the euro should combine to push headline inflation well below 2 percent by late 2004. Directors saw the costs of undershooting the inflation objective as greater than those of overshooting it. Low inflation would not help balance sheet adjustments and would provide less room for, and, hence, increase the costs of, relative price adjustments across the area. This, Directors observed, together with the risk of euro appreciation, strengthened the case for monetary policy to maintain an accommodative bent in order to support confidence until a self-sustaining upturn in domestic demand is in place.

There is a need for forward-looking fiscal policies to improve the quality and ensure the long-term sustainability of public finances in light of potential fiscal pressures created by population aging. In this regard, the Board noted that fiscal developments have not been positive, particularly in the three largest economies, where most policies have had a short-term focus, and fiscal excesses during the boom years contributed to difficulties in observing the nominal deficit ceiling. Directors agreed that these developments underlined the need for a fiscal framework in the European Economic and Monetary Union (EMU). Directors felt that, from a longer-term standpoint, the basic parameters of the EU Treaty and Stability and Growth Pact (SGP) were broadly appropriate. Noting the focus on breaches of the 3 percent deficit limit, Directors stressed that past lapses in fiscal discipline, and not the fiscal framework itself, had been responsible for the limited amount of fiscal leeway in the three largest euro area economies. The aging of the population requires that most euro-area countries move at least toward underlying balance over the medium term. If they did so, there would be room for the automatic stabilizers to work, and the 3 percent limit would not be binding aside from exceptional circumstances, which the pact allows for.


The IMF’s FY2004 policy dialogue with the Japanese authorities focused on initiatives that could stimulate high and sustained medium-term growth. In recent Article IV consultations, the Fund emphasized the need to revitalize the corporate and financial sectors, tackle deflation, put the fiscal balance on a sustainable medium-term footing, and undertake regulatory reforms to facilitate the reallocation of resources.

The authorities shared the Fund’s view and have taken steps to address these issues. They have fashioned a framework for corporate restructuring, strengthened bank supervision and regulation, taken monetary policy steps to counter deflation, reduced and allocated public works spending more efficiently, and started to deregulate important sectors.

In addition, Japan participated in the Financial Sector Assessment Program. The authorities will continue to address issues identified by the assessment, which stressed the need for the government to pursue further banking reforms and to reduce its involvement in Japan’s banking sector over the medium term.

Japan-IMF activities in FY2004
August 2003Completion of Article IV consultation by the Fund’s Executive Board
September 2003Publication of Financial System Stability Assessment and supplementary information
February 2004Visit of Managing Director Horst Köhler

There was a potential conflict between the short-term need for fiscal stimulus to boost economic growth and the need for fiscal consolidation to restore the credibility of the SGP and to achieve fiscal sustainability. However, Directors believed that more forward-looking fiscal policies could provide a bridge to long-term sustainability while permitting greater short-run flexibility. The SGP should indeed focus on growth as well as stability, but that growth means first and foremost structural reforms rather than short-term demand management. Within such a framework, most Directors acknowledged that there was scope to trade short-run fiscal consolidation for credible multiyear commitments to growth- and consolidation-oriented structural reforms, notably by cutting spending and increasing incentives rather than raising taxes. Although it was recognized that this entails credibility risks for the SGP insofar as it implies further breaches of the 3 percent deficit limit, the standard remains that countries with weak underlying positions should take discretionary fiscal policy actions to achieve underlying high-quality fiscal adjustments of 0.5 percent of GDP a year. Many Directors agreed, however, that, where underpinned by meaningful gains on the long-run structural and macroeconomic fronts, delays that meet the standard on a cumulative basis—that is, 1.5 percent of GDP—during 2004-06 would also strike an appropriate balance between long- and short-run goals. A number of Directors, though, cautioned against departures from commitments to achieve a steady underlying fiscal adjustment of 0.5 percent of GDP a year.

Board members called for more sustained and vigorous implementation of structural reforms. They noted that, while the area’s low underlying growth rate reflects, in large part, slow population growth, there was considerable scope for raising rates of utilization of labor resources and for increasing technological progress and innovation. Long lags in effecting increases in labor force participation rates require early concerted actions to slow—if not reverse—the aging-induced fall-off in potential per capita growth and deterioration in public finances. In this context, Directors emphasized the importance of labor market and pension reform. The loss of the exchange rate as an adjustment mechanism within the monetary union, particularly in the context of limited labor mobility, makes greater flexibility in goods and labor markets imperative.

The promising reform steps recently taken in some countries was welcomed by Directors, but they emphasized that much more is needed to achieve the goals set out in the Lisbon agenda agreed by the European Council in 2000. Directors were particularly encouraged by progress in creating a single market for financial services. Moreover, the reform process in the larger countries, particularly with respect to labor markets and social security systems, had been revived. In some cases, progress surpassed earlier expectations. There was also a growing recognition of the largely unexploited synergies to be reaped between structural reforms, improved economic performance, and fiscal sustainability. These synergies hold the promise of improving medium-term growth prospects and restoring the credibility of the SGP. However, Directors noted that the agenda of needed reforms was long and varied across countries, while resistance to reform remains strong and is likely to strengthen as the economic situation improves. It is essential that the new reform momentum not become simply a response to economic adversity but that it be sustained for many years to come. Directors, therefore, welcomed the steps taken by the Commission and endorsed by ECOFIN to toughen surveillance by making the Broad Economic Policy Guidelines both more targeted and more forward-looking.

Directors endorsed the recent decision to reform the Common Agricultural Policy, noting that the agreed “decoupling” of agricultural supports from production would lessen downward pressures on world prices. Many Directors noted that greater commitment to opening EU markets will be crucial to achieving the objectives of the Doha Round of multilateral trade negotiations and that creating a multilateral trade environment supportive of economic development and poverty reduction would require more concessions by the EU and other advanced economies to developing countries.

Adopting the Euro in Central Europe

In February 2004, Executive Directors discussed the challenges facing the five former transition countries of Central Europe (CECs)—the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia—as they moved toward the adoption of the euro along with the Baltic states, Cyprus, and Malta.

The discussion focused on how best to address two fundamental questions: when to adopt the euro, and how to prepare for it. Directors noted that, while all countries acceding to the European Union faced challenges, the macroeconomic issues surrounding euro adoption would be especially complex for the CECs, which maintained flexible exchange rate arrangements. They observed that addressing these issues would require careful case-by-case assessment, and the path and pace of euro adoption would differ according to individual country circumstances.

Euro adoption is likely to bestow substantial benefits on the CECs over the long term, Directors noted, provided strong supporting policies are in place. These benefits would stem from the elimination of exchange rate risk, lower transaction costs, enhanced policy discipline, lower real interest rates, and greater transparency of prices. Although difficult to quantify, the benefits would be manifested primarily through increased trade and investment and more rapid productivity and income growth. Directors stressed that, to realize these gains, the countries would need to secure sound macroeconomic and structural conditions and continue to foster private sector development. In particular, goods and factor markets should be flexible, and public finances should be put on a sustainable track with minimal rigidities from nondiscretionary spending. Directors noted that the CECs’ policy strategies were already on a promising path toward fulfilling these conditions in many important areas.

Adopting the euro would also entail costs stemming from the loss of the monetary policy instrument, Directors observed, given the role that monetary policy can play in offsetting asymmetric demand shocks and providing an instrument for containing demand pressures. While further convergence of business cycles would help to minimize the risk of asymmetric shocks, countries would be well advised to build up sufficient policy flexibility to deal with any remaining shocks prior to adopting the euro. Joining the euro area would effectively eliminate the high degree of exchange-rate-induced volatility to which CECs are exposed.

The path to euro adoption involves participation in the Exchange Rate Mechanism (ERM2) and meeting the Maastricht criteria. The Board’s discussion confirmed that decisions on the timing of these steps would need to be made on a case-by-case basis, taking into full account the policy issues involved. Three considerations appear to be of primary importance to ensure that the euro candidates will be well prepared for successful participation in the EMU.

  • Prior to adopting the euro, the harmonization of economic conditions—particularly the correlation of business cycles and trade links—should be strong. While business cycles can be expected to become even more synchronized once countries adopt the euro, a sufficient degree of cyclical convergence, prior to euro adoption, would help improve prospects for a successful experience in the euro area.

  • Adjustment mechanisms—wage and price flexibility and the capacity to run countercyclical fiscal policy—would need to be in place to ensure that asymmetric shocks can be effectively absorbed in the absence of monetary policy.

  • Euro candidates must achieve an adequate degree of nominal convergence. Directors indicated that the issue of how best to assess the appropriate standards for nominal convergence deserved further reflection. Several Directors saw the proposal to use the ECB’s inflation objective as the basis for defining “best performing in terms of price stability” when setting the Maastricht inflation ceiling as judicious. This approach would ensure that appropriate consideration is given to the conditions prevailing in the candidate countries. However, others cautioned against interpretations of the Maastricht Treaty criteria that could raise issues of unequal treatment of new and current members.

Meeting these conditions will require further strong efforts, but Directors noted that, in many respects, in particular progress with trade integration, the CECs were already at least as well positioned as some of the current EMU members were at the same stage of the accession process.

The discussion highlighted several sources of vulnerability that would need to be carefully managed. Directors noted that the CECs would continue to attract capital inflows that could be volatile by virtue of their size and susceptibility to speculation about the timing and conditions of euro adoption. They also noted that the prospect of rapid credit growth starting from the present low rates of bank intermediation entailed possible risks of overheating and asset price bubbles. Sound and consistent macroeconomic policies and strong and effective bank supervision would be key to minimizing these vulnerabilities and positioning the CECs for a successful experience in ERM2 and the early years in the euro area, Directors cautioned. While it was acknowledged that temporary restrictions on capital inflows could, in some limited circumstances, play a complementary role, it was also considered that this option would go against the objective of greater integration.

Directors agreed that further progress toward fiscal consolidation would likely be the greatest challenge facing the CECs in preparing for euro adoption. They noted that fiscal consolidation would require both the articulation of credible plans for medium-term fiscal adjustment based on a strong consensus and the demonstration of sustained progress in meeting adjustment goals. It was also suggested that the CECs should stand ready to accelerate the pace of fiscal consolidation in the event of a boom in bank credit. While they acknowledged the challenge of reaching this objective in practice, Directors saw considerable merit in a medium-term strategy that would bring structural fiscal deficits well below the Maastricht deficit criterion of 3 percent of GDP by the time of euro adoption, with a view to allowing the full operation of the automatic stabilizers in the event of adverse cyclical conditions. Lower deficit levels would also help the CECs achieve public debt ratios that are sufficiently prudent given the volatility of fiscal revenues and the extent of expenditure rigidities. At the same time, the need to maintain public investment at levels that support further real convergence underscores the importance of high-quality fiscal adjustments focused on restraining the least productive expenditures, in particular social transfers and subsidies.

The discussion raised several important aspects of ERM2 in the run-up to euro adoption. Decisions about the central parity at which the CECs would enter the mechanism will require difficult and delicate judgments about where the parity should be set given the uncertainties as to the equilibrium exchange rate. In any event, participating members would have to agree on the parity and conversion rates.

Participation in ERM2 would also require well-planned policy strategies on the part of the CECs. There was support for the view that countries should apply to enter ERM2 only after they have made substantial progress toward achieving low inflation, correcting fiscal imbalances, and implementing structural reforms. This would allow the stay in ERM2 to be limited to the minimum two-year period. However, there was also support for the view that ERM2 would provide participating countries with a useful and flexible framework for testing policy consistency and the appropriateness of the central parity, and for helping them direct economic policies toward sustainable convergence and reduced exchange rate variations. In this view, there are good arguments against any bias toward shortening the length of stay in ERM2, which may need to vary across countries. At the same time, the discussion highlighted that the conversion to the euro should not be unduly delayed for countries entering ERM2 with sound fundamentals and policies consistent with full participation in the euro area, given the potential risks of speculative pressures related to a prolonged stay in ERM2 and the obligation set out in the Maastricht Treaty to move toward euro adoption once all criteria are fully met.

Directors pointed to the importance of a clearly defined monetary policy framework during ERM2. With the support of sound underlying policies, the aim should be to put in place a framework that enhances the stabilizing effects of an appropriately set central parity, strengthens the likelihood of achieving the criteria for exchange rate stability and inflation, and offers protection against speculative pressures. Directors discussed a variety of possible frameworks but cautioned that no single monetary regime met the requirements of all countries. They accordingly stressed the constructive role the IMF staff and regional institutions could play in encouraging national authorities in candidate countries to make choices on their monetary policy frameworks with a full appreciation of the trade-offs and risks involved. Directors also stressed the need for chosen frameworks to provide markets with a clear indication of how monetary policy would respond to various types of potential shocks.

Lastly, the Board underscored that, given the considerable policy challenges ahead, each country will need to place a high priority on building broad-based support for its euro adoption strategy. Maintaining clear and timely communication with the markets, and between the CECs and the European Commission and the ECB, will help in this task. This will also involve minimizing any uncertainties about the criteria to be used in assessing compliance with the requirements for euro adoption while preserving the room for using judgment when making the final assessment of compliance with the Maastricht criteria.

Central African Economic and Monetary Community

In November 2003, Directors discussed developments and regional policy issues in the Central African Economic and Monetary Community (CAEMC), whose members are Cameroon, the Central African Republic, Chad, the Republic of Congo, Equatorial Guinea, and Gabon.

Macroeconomic developments in the CAEMC region were generally satisfactory in 2002, with growth remaining buoyant, inflation moderate, and the level of official reserves rising. However, the region remained excessively dependent on the oil sector, and human development indicators had improved only marginally despite the region’s endowment of natural resources. More broadly, Directors considered that greater convergence in members’ fiscal, monetary, and trade policies would help CAEMC realize the full potential of regional economic integration.

Against that background, Directors regretted the slow progress in macroeconomic convergence and urged greater political commitment to, and strengthening of, the surveillance process. They welcomed the introduction of improved convergence criteria and suggested further strengthening the peer review process. Given the volatility of oil revenues, they encouraged the CAEMC authorities to modify the basic fiscal balance criterion by using a fiscal rule and to introduce greater transparency in the management of oil resources in line with international best practices. Directors welcomed the plans for making the administration of national stabilization funds and “Funds for Future Generations” more flexible and suggested that consideration be given to improved ways of investing these resources with the Bank of Central African States (BEAC).

As for monetary policy, Directors considered the BEAC’s stance in 2002 to have been generally prudent, and the 2003 monetary program was broadly consistent with the regional inflation objective. However, Directors noted that more progress was needed in removing the long-standing structural weaknesses that hinder the effective conduct of monetary policy in the region. Directors urged the CAEMC authorities not to delay further the replacement of the BEAC financing of budget deficits by the issuance of treasury bills. In that context, they encouraged the BEAC to consider issuing its own negotiable certificates of deposit to enhance its liquidity-management capacity until government treasury bills become more generally available. Directors also considered that country-specific reserve requirements might create distortions across the region’s financial markets, which could impair the competitiveness of financial service providers in some member countries, and called for their realignment. Board members also called for additional measures, such as freeing up interest rates, improving the payments system, and simplifying the procedures used for open market operations, to enhance the functioning of the interbank market.

Continued efforts were needed to strengthen the banking system, which remained fragile despite the restructuring of distressed banks, and Directors emphasized the role of the Banking Commission of Central Africa (COBAC) in ensuring banks’ compliance with prudential norms. They recommended that COBAC be made the sole authority for issuing and withdrawing bank licenses, and that the common bank licensing rules be revised to further facilitate opening of bank branches across the region. Directors welcomed COBAC’s plans for progressive tightening of the capital adequacy ratio, but highlighted the need to match capital requirements to the high operational risks inherent in CAEMC economies because of their undiversified economic structure.

Directors encouraged the CAEMC authorities to press ahead with other financial sector reforms, including early and effective implementation of new regulations for the microfinance sector. They welcomed the adoption of anti-money-laundering regulations, but noted that additional steps were needed to make them fully operational. In light of the modest size of the private sector in CAEMC countries, Directors expressed a preference for merging the nascent regional stock exchange in Libreville with the existing one in Douala. There is merit in adopting a prudent approach in the operations of the recently reorganized regional development bank (BDEAC) so as to confine its lending operations to refinancing activities in accordance with sound financial criteria, relying on its own funds and long-term resources borrowed on the regional market.


Mozambique completed four IMF-supported programs during 1987-2003. These programs helped the country make significant structural reforms-moving from a centrally planned economy to a market-based one-achieve macroeconomic stability, and substantially reduce its debt burden. GDP growth averaged nearly 7 percent a year during this period. The country built up its foreign exchange reserves, and the net present value of Mozambique’s public external debt fell from over 500 percent of exports at the end of 1998 to less than 100 percent at the end of 2003. The proportion of the population living below the poverty line has declined by about 15 percentage points since 1997, when it was 70 percent.

The government’s program for calendar year 2004 calls for broadening and sustaining growth by maintaining prudent macroeconomic management and addressing an important agenda of unfinished reforms to accelerate private sector development.

The Fund provides significant levels of technical assistance in the financial and fiscal sectors in close cooperation with development partners, which also contribute financial support. This assistance has enabled Mozambique to make great strides in strengthening public finances, including customs and tax administration.

Mozambique-IMF activities in FY2004
June 2003Completion of the fifth review of Mozambique’s performance under the country’s PRGF-supported program
July 2003Visit of Managing Director Horst Köhler, who also attended the second African Union Heads of State meeting in Maputo
November 2003Mozambique began participating in the Fund’s General Data Dissemination System; publication of Financial System Stability Assessment by the IMF and the World Bank
December 2003Completion of Article IV consultation and ex post assessment of Mozambique’s performance under Fund-supported programs by the Fund’s Executive Board

Directors regretted that member countries still do not consistently apply the provisions of the common external tariff (CET), and they saw expediting trade integration among CAEMC nations as urgent. Remaining non-tariff barriers need to be eliminated; customs codes, valuations, and exemptions need to be harmonized; and the CET needs to be overhauled, including by reducing the top tariff rate of 30 percent. Directors encouraged the authorities to pursue tax harmonization in other fiscal areas as well and to strengthen the collection of the regional tax on imports to ensure financing of the regional institutions and regional integration funds.

Some of the competitiveness gains resulting from the 1994 devaluation of the CFA franc had been eroded, Directors observed. To maintain the region’s external competitiveness and its share in export markets, they underscored the need to pursue policies aimed at broadening the productive base and diversifying the economies, including by accelerating structural reforms, strengthening basic infrastructure, and adopting common sectoral policies.

Directors urged the authorities to improve the quality, harmonization, and distribution of CAEMC’s economic data, notably in the areas of price indices, the real sector, and public finance. In light of the high incidence of poverty in the region, the collection of social sector statistics to track progress with poverty reduction and human development indicators was especially important. Directors supported elevating the regional discussions on economic developments and policies to the level of formal regional surveillance of CAEMC-wide issues in the context of Article IV consultations with member countries.

Structural Reforms and Growth

A common theme in many of the Executive Board’s discussions during the financial year was the need in many countries for more vigorous efforts at structural reform, especially to enhance economic growth. The theme arose in a variety of contexts: not only in surveillance discussions at the country, regional, and global levels, but also in discussions of policy programs supported by IMF financing.

Many economic problems are due to shortcomings in the working of markets, rather than to resource shortages or an excess or deficiency of overall demand. There is broad consensus that where there are such problems, structural reforms—policy measures that change the institutional and regulatory frameworks governing market behavior—can lead to greater efficiency in the allocation and use of resources and to stronger incentives for innovation, and thus not only to higher productivity and per capita incomes but also to faster long-run growth. Structural reforms can also boost growth in the short run by increasing returns to investment and by providing scope for macroeconomic policies to allow the economy to run at higher levels of capacity utilization without inflationary pressures. Unfortunately, however, many structural reforms impose costs on a few individuals or social groups in the short run, and those who perceive themselves as potential losers often successfully oppose reforms.

For the April 2004 World Economic Outlook, an IMF staff team researched structural reforms in industrial countries to distill lessons from the experience of the past three decades, particularly on the obstacles to reform and what can be done to overcome them. The analysis suggested that several considerations could make a difference in the success of reforms:

  1. A recovery from an economic downturn is a good time to start reforms. Difficult economic conditions often make the need for reform more obvious, thereby weakening traditionally strong interest groups.

  2. There are advantages to starting with reforms that bring quick, clear benefits. Trade and financial market reforms, for example, produce benefits in the short run. If these are successful, they not only have a demonstration effect but may also increase competitive pressures, making further reform easier.

  3. Strong fiscal positions enable countries to provide compensation to those hit hardest by reforms, suggesting that countries should seek to improve their fiscal positions to gain the flexibility to support reforms in this way.

  4. Outside support for reforms can be helpful. Signing an international agreement or joining an international club can provide external discipline that will force the pace of reforms. For example, membership in the World Trade Organization provides support for trade liberalization. Membership in the IMF is another example.

Through the Fund’s surveillance, financial assistance, and technical assistance, the Executive Board continued in the latest financial year to press for structural reforms in many countries and highlighted the success of past reforms.

In its surveillance of policies in the industrial countries—in its discussions of the World Economic Outlook and the relevant country surveillance cases—the Board observed that growth-enhancing structural reforms were particularly important for both the euro area and Japan, which have suffered sluggish growth in recent years because they lacked the scope to ease macroeconomic policies, given the already low level of interest rates as well as actual and projected fiscal imbalances. Structural reforms in the euro area and Japan were thus seen as an important component of the policies needed to rebalance global growth and narrow payments imbalances. The Board also emphasized the importance of labor market reforms in many European countries to tackling problems of chronic unemployment.

For many emerging market countries, the Board emphasized the importance of fiscal and financial sector reforms to make growth more robust. The three Baltic countries—Estonia, Latvia, and Lithuania—are examples of successful reformers in which the Fund was able to play a crucial role in guiding the authorities in making difficult choices. These three countries have recorded growth rates of 6 to 9 percent annually, with low inflation, over the past few years despite a difficult global environment—a remarkable recovery from the recession triggered by Russia’s financial crisis of 1998. The recovery was due, in large part, both to sound macroeconomic policies and to the implementation of often painful structural reforms in anticipation of European Union accession in May 2004.

For many low-income countries, the Board stressed, in particular, the need for reforms that would improve governance and other features of the investment climate, because of the importance for growth and poverty reduction of attracting private investment—including from abroad—and fostering domestic saving.

Specific reform agendas in the financial sector, trade and tax systems, and product and labor markets were discussed in many Article IV country consultations and in multilateral and regional surveillance activities. Instances of how various countries have benefited from structural policy assistance as well as from macroeconomic advice provided by the Fund appear throughout this report.

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