Developments in the Major Currency Areas

In considering developments in the United States, Directors saw few signs of slowing economic activity despite several interest rate increases by the U.S. Federal Reserve; indeed, growth accelerated toward the end of 1999. They suggested that the combination of strong investment and productivity growth, subdued wage pressures, and ongoing low inflation—resulting from fundamental changes in the economy—had raised the U.S. potential growth rate. Nevertheless, many Directors were concerned about rising internal and external imbalances in the economy that had accompanied the prolonged expansion, including a record-high current account deficit, strongly negative net private saving, and high stock market valuations. Directors recognized the central role that U.S. demand had played in supporting recovery worldwide, as well as the importance of the strong domestic investment climate and increases in national saving in the evolution of the current account. Many Directors agreed, however, that some further firming in U.S. interest rates would probably be unavoidable, absent clearer signs of a moderation in demand. Such a strategy would improve the prospects for a “soft landing” in the economy, whereas a delayed response could increase the risk of a further buildup of the imbalances and of a subsequent “hard landing.” A more balanced pattern of global growth would help reduce the U.S. external deficit.

Some Directors noted, however, that further increases in U.S. interest rates could set back the prospects for sustained recovery in some key emerging market economies, notably among the Latin American countries requiring significant external financing in the coming years. These Directors advocated a cautious approach to further monetary tightening and considered that, alternatively, reliance on further fiscal consolidation to slow domestic demand growth would avoid the risk of spillover effects on world capital markets. They recognized, however, that implementing further fiscal tightening with a budget already in surplus could prove politically difficult. More generally, Directors agreed that further fiscal stimulus, whether through substantial tax cuts or spending increases, would be dangerous under the circumstances. Instead, they argued that the welcome increases in public saving should be assigned largely to reducing debt and meeting the longer-term fiscal requirements associated with an aging population.

Turning to Japan, Directors agreed that economic indicators provided unclear signals regarding prospects for recovery. The data on fourth-quarter 1999 GDP, along with trends in household spending, confirmed that real activity had again weakened following the short-lived upturn in the first half of 1999, while the index of leading indicators provided scope for more optimism about the economic outlook.

Most Directors considered that a strong, self sustaining recovery in Japan led by private domestic demand still appeared some distance away, and that supportive macroeconomic policies should therefore be maintained. Directors agreed that Japan’s zero interest policy remained appropriate for monetary policy, with several suggesting a further easing of monetary conditions, especially if the yen were to appreciate again. Some Directors also considered that the introduction of an inflation-targeting framework could help improve the monetary framework. Most Directors believed that fiscal policy also should continue to support recovery, although a number of them suggested that the focus should soon start moving toward fiscal consolidation, given the rapid rise in public debt, pressures on longer-term interest rates, and the need to deal with the approaching fiscal pressure from public pension arrangements. In this connection, several Directors were concerned about the efficacy of successive fiscal packages to put the economy on a self—sustained growth path. Directors underscored the crucial role of structural reforms in boosting confidence and thus enhancing the efficacy of Japanese macroeconomic policies, noting also that with zero interest rates and high levels of public debt, the scope for continued expansionary macroeconomic policies might be reaching its limits. Against this background, Directors were concerned about delays in implementing some important structural reforms, and what they perceived as a weakening of other initiatives. They believed that, while structural adjustment could have a downside impact on some sectors, this would be more than offset over time by the broader-based improvements in confidence and activity that would follow from measures to liberalize domestic markets, strengthen the financial system, and address other structural weaknesses.

Directors welcomed the pickup in confidence and activity in the euro area. They noted the improvements in economic performance of the largest economies in the region, but observed that growth remained substantially more dynamic in several of the smaller countries. Fiscal policy had to play a central role in moderating risks of overheating among the fast—growing economies, even though fiscal adjustments might be politically difficult given the emerging budget surpluses in some of these countries. A broad program of fiscal reform was also required in most euro-area economies to reduce current and longer-term expenditure pressures and provide greater scope for tax relief. Directors argued that the recovery under way provided an important opportunity to push ahead with these fiscal reforms, and with complementary structural adjustment—especially in labor and product markets—to help sustain the recovery. While all Directors agreed that monetary policy should continue to focus on maintaining low inflation, some thought that monetary conditions should continue to support recovery in view of the slack still evident in the region. Some other Directors, however, suggested that firming monetary conditions could be expected in the year ahead, given the risk of price pressures—including in asset markets–developing in some countries.

Asset Prices

In considering developments in the advanced countries, Directors gave particular attention to trends in asset prices. They noted that asset price inflation was a general concern, encompassing the United States and much of western Europe. High asset prices posed a formidable challenge for macroeconomic policy in the prevailing environment of low inflation in goods and services markets. On the one hand, given the practical difficulties in determining the equilibrium value of asset prices and the fact that they are traded in relatively efficient markets, Directors felt it was unsuitable for macroeconomic policy to try to target those prices. On the other hand, as rapid and prolonged buildups in asset prices might worsen inflationary pressures and threaten financial stability through their impact on aggregate demand and domestic credit, asset price developments could well be a serious concern for central banks. Directors agreed that, to the extent asset prices provided valuable information about future developments in economic activity and inflation, such information should be taken into account in inflation and monetary targeting frameworks—but that prices of goods and services should remain the policy target. While agreeing that targeting asset prices should not become a permanent policy goal, some Directors considered that there may be instances in which macroeconomic policy should “lean against the wind” and try to stem financial market excesses, even though inflation in goods and service markets remained quiescent–although they recognized the practical difficulties in determining when and to what extent such a policy should be implemented.

In the United States, Directors noted that, despite some uncertainty, many valuation analyses pointed to some degree of overvaluation in key broad indices. In light of evidence that wealth effects stemming from the stock market might contribute to fueling growth of domestic demand well in excess of increases in potential output, Directors felt that the U.S. steps to tighten monetary conditions had been appropriate—and that the need for further tightening would have to be kept under close review.

As for the euro area, Directors agreed that the main challenge for macroeconomic policy arising from asset price movements remained the magnitude of regional divergences, with property prices, in particular, rising far more rapidly in some fast-growing euro-area countries on the periphery than in the region as a whole. While faster growth on the periphery was at least in part justified by regional convergence in incomes associated with economic integration and the introduction of the euro, the potentially significant impact of asset price corrections on financial conditions in some small European countries posed a problem for the conduct of monetary policy.

Prospects for Emerging Markets

Turning to economic developments in Asia, Directors welcomed the rapid recovery in the crisis-affected countries and the projections of continued strong growth. Rising exports had played a key role in this recovery, adding to the support from public spending and, more recently, from private domestic demand. Directors agreed that fiscal stimulus should be steadily withdrawn as growth became self-sustaining. Indeed, several Directors suggested that in the countries with recoveries most advanced, macroeconomic policies should focus on reducing risks of overheating and containing the growth in public debt. Directors urged the crisis-affected countries to maintain the momentum of structural reforms—especially in the financial and corporate sectors and in the institutional and prudential framework—and cautioned that the recoveries could prove short-lived if these reform efforts were relaxed. And to maintain the prevailing robust growth rates in China and India, further structural reforms were needed.

In Latin America as a whole, the downturn in 1999 had proved to be milder than expected because of the sustained pursuit of prudent macroeconomic and structural policies, although several countries experienced severe recessions. Directors agreed with staff projections that a broader-based recovery should emerge in 2000 and continue into 2001. Several elements were contributing to the improvement in regional economic conditions; these included strong growth in the United States, rising commodity prices, and declining inflation and interest rates. Nevertheless, several Directors cited remaining vulnerabilities—especially the high external financing needs of the largest countries and persistent weaknesses in some smaller economies. Directors urged these countries to continue to take steps to reduce risks and maintain the confidence of international investors. Key measures would include reducing fiscal deficits, where further progress was expected in 2000; implementing monetary policy frameworks designed to achieve or maintain low inflation; and, to support these objectives, enacting further structural and institutional reforms, including greater trade liberalization. Directors also emphasized the importance of increasing public and private domestic saving to help reduce reliance on foreign financing.

Russia’s economy experienced a rapid turnaround in 1999, but prospects for a sustained recovery remained uncertain. The reductions in Russia’s fiscal and external imbalances in 1999 largely resulted from higher oil prices, with import compression and substitution also contributing to growth. Directors agreed that a firm and wide-ranging reform effort was needed to improve the investment climate and medium-term growth prospects. Priority had to be given to strengthening the institutions and processes that underpinned market economies—including the legal framework, competition policy, transparency, and governance. Such reforms would reinforce efforts to tackle key structural weaknesses in the economy, particularly in the tax regime, in the banking system, and in many parts of the corporate sector.

Economic conditions were strong among the central and eastern European transition economies seeking accession to the European Union (EU). Growth was expected to pick up in all these countries in 2000, helped in most cases by growing exports to western Europe and stronger investor confidence. But further progress with structural adjustment would be needed for sustained improvements in economic prospects and to prepare for eventual EU membership. In some countries, more rapid progress with fiscal consolidation was also desirable as growth strengthened, to reduce pressures on inflation and interest rates.

For many countries in the Middle East and several in Africa, the rise in international oil prices had contributed to improvements in fiscal positions, current account balances, and other dimensions of economic performance. Increases in some nonoil commodity prices (such as metals) also supported external earnings growth in several African countries, although low prices for other products (such as tea, coffee, and cotton), combined with unfavorable weather (particularly in Mozambique), had slowed growth prospects elsewhere. In this regard, Directors agreed on the importance of continued economic diversification to reduce these countries’ vulnerability to swings in the prices and volumes of commodity exports. They were encouraged that substantial progress had been made in these regions, including among many of the smaller countries in Africa, in laying the groundwork for broader-based growth. In view of the remaining economic and social challenges, these reform efforts had to be expanded to make substantial inroads on poverty and provide a better environment for economic development.

Strengthening Growth in the Poorest Countries

At their March 2000 discussion of the World Economic Outlook, Directors also reiterated their commitment to policies aimed at raising the living standards of the least well-off. Although economic performance in most developing countries had on average been unsatisfactory over the past 30 years, Directors were generally encouraged by gains in real per capita income in many poor countries in Asia—notably in China and India–and, more recently, in several countries in Africa, where programs directed at achieving reasonable price stability, prudent fiscal balances, and sustainable exchange rate regimes had been successfully implemented.

Directors emphasized the critical relevance for economic development of market-friendly institutions and an environment in which individuals and businesses could save and invest, and expect to enjoy the future benefits of their endeavors. Political instability, war, and the absence of the rule of law were critical impediments to such a setting and to development more generally. Directors called for continued progress in removing distortions in domestic markets by eliminating price controls and subsidies, liberalizing external trade, and combating corruption through effective and transparent government. Many developing countries also had to establish sounder financial markets to allocate efficiently savings to profitable investments. Many of these countries, especially the poorest, would also benefit from giving higher priority to health and education programs to help break the poverty cycle by increasing productivity. Directors cautioned, however, that there was no unique formula for starting and sustaining economic growth; each country would have to decide how best to provide the necessary fundamentals for economic prosperity through the combined efforts of government and representatives of civil society. In this respect, Directors emphasized that local “ownership” of the reform process was crucial to its success.

Unsustainable levels of external debt are a critical impediment to economic growth and poverty alleviation, especially in some of the poorest countries. Without significant debt relief, incentives for government reform and private investment are dulled, and countries can be caught in a vicious debt and poverty trap. Directors emphasized the opportunity provided by the recently enhanced Initiative for Heavily Indebted Poor Countries (HIPCs), under which debt would be lowered to sustainable levels through concerted efforts by the international community (see Chapter 5).

Directors recognized the important contributions to debt relief being made by the membership, and in particular the advanced economies, both directly and through international organizations. Several Directors called for a reversal in the downward trend in official development assistance, and cautioned that debt relief associated with the HIPC Initiative should not be seen as a substitute for future development assistance.

These Directors drew attention to the more effective use of development assistance, for example, through strengthened incentives for reform in the recipient countries and through better targeting of aid to address these countries’ needs. Many Directors also called on advanced economies to enhance the effectiveness of the HIPC Initiative by reforming their trade policies, especially in such areas as agricultural products and textiles, where current policies had particularly damaging effects on trade opportunities and growth prospects for developing countries.

International Capital Markets

At the end of July 1999, Executive Directors conducted their annual review of developments in, and prospects for, international capital markets. Directors also discussed the lessons learned from the 1998 global financial market turbulence and the emerging market crises. Although financial market conditions had improved in the past year, Directors underscored some risks and uncertainties in the outlook. They differed about the lessons of the turbulence of 1997-98 and the initiatives being considered to address shortcomings in the global financial architecture. Although Board members broadly supported efforts to enhance market discipline, prudential supervision, and regulation, they achieved less consensus on the specific measures to be taken and whether the problem of ensuring appropriate incentives was being adequately addressed. The risks of globalization and how to address them, Directors agreed, should remain at the center of the IMF’s research activities.

Issues and Risks

As of July 1999, the Board noted that the operation of international capital markets was considerably more favorable than in 1998, but cited several remaining risks and uncertainties, and sentiment was still unusually fragile. Even though financial market activity had in many respects returned to normal in the advanced countries, external financing remained unusually tight for many emerging markets. Spreads on these countries’ external debt instruments remained in several cases very high, and internationally active banks continued retreating from the emerging markets. As a result, volatility continued to be high and significant vulnerabilities remained.

The continued strong macroeconomic performance of the U.S. economy, signs of a broader pickup in continental Europe, and Japan’s progress in addressing its financial sector and macroeconomic problems augured well. The main risks related to the sustainability of the current combination of exceptionally high U.S. equity prices and U.S. dollar strength and the possibility that either a spontaneous reassessment or further moves by the Federal Reserve to tighten monetary policy could trigger a significant correction in equity prices. While many Board members were confident that the advanced countries could withstand a modest U.S. equity correction, a number of Directors felt uncertainty about the extent and distribution of leverage in advanced financial systems that risked a more severe fallout—one with adverse implications for the emerging markets, especially countries whose markets were already weak.

While welcoming the rally in emerging market asset prices since the start of 1999, a number of Directors pointed to the risks resulting from continued tight external financing conditions and the ongoing pullback of international investors. This reduced access to capital markets had put severe pressures on several emerging market banking systems; this, in turn, contributed to cutbacks in local funding for domestic corporate securities, making debt service more difficult. A number of Directors noted that a vicious cycle had been evident since Russia’s August 1998 unilateral debt restructuring, as pullbacks of international investors from emerging markets contributed to low liquidity and relatively high volatility, which in turn discouraged participation by other investors. While expressing some confidence about the near-term outlook, some Directors remained concerned about the degree of effective financial and corporate restructuring in several of the Asian-crisis countries.

Turbulence in Mature Markets and Highly Leveraged Institutions and Activities

Executive Directors discussed the systemic and other issues related to highly leveraged institutions and activities in 1998 and the reforms being considered to contain excessive leverage. The buildup of financial risks that preceded the 1998 turbulence had raised important questions about the current lines of defense against systemic risk—especially weaknesses in market discipline, prudential supervision and regulation, and macroprudential surveillance. Directors differed somewhat, however, on the importance of different lines of defense and what could be done to strengthen them. While a few Directors argued for direct controls over hedge funds, most saw major difficulties in seeking to regulate these institutions directly; they supported ongoing efforts—including by the Basel Committee on Banking Supervision—to influence hedge funds indirectly by significantly strengthening oversight by counterparty banks and through improved market discipline.

Many Directors believed insufficient market discipline by creditors, counterparties, and shareholders was a key element allowing the buildup in vulnerabilities and leverage that preceded the 1998 turbulence. These Directors believed that the lack of adequate market discipline may have reflected other, more fundamental, deficiencies that pointed to the need for improving financial disclosure and transparency and better aligning internal, market, and regulatory incentive structures. In this connection, several Directors saw a key challenge for private financial institutions and for public policy in maintaining the efficiency enhancing aspects of modern finance while reducing the system’s tendency toward financial excesses and virulent market dynamics. Several Directors noted that more proactive prudential supervision and market surveillance could help detect and avoid a buildup in vulnerabilities. They suggested that the presence of the public safety net for financial institutions created countervailing incentives that may work against market discipline. Some Directors felt that the staff’s analysis could have given further consideration to the issue of moral hazard and to the analysis of options to reduce it; some others, however, were not convinced that safety nets had given rise to moral hazard or had been excessive. Directors agreed that the ability to supervise and monitor modern financial systems would remain critical.

Directors unanimously welcomed the reform proposals on improved transparency and disclosure by both private sector groups and officials. Such proposals would likely require all financial institutions—including highly leveraged institutions—to provide more information. An important next step was to agree on a core set of data on firms’ risk exposures, and on the frequency with which it should be disclosed to market investors, counterparties, and, where relevant, supervisors.

Many Directors observed that greater disclosure and improved transparency may not in themselves be sufficient to improve credit and counterparty risk assessment; rather, internal incentive structures were required to encourage firms to obtain information and act upon it. Several Directors felt that current reform proposals did not generally address the need for such changes in incentives. In this connection, a number of Directors pointed to the proposed revisions to the Basel Capital Accord as a first step toward correcting possible regulatory distortions.

Several Directors expressed concern that the ongoing rapid pace of financial liberalization, innovation, and globalization was contributing to changes in the nature and sources of systemic risk that were not fully understood. They thus suggested the need for additional consideration of how regulators who supervise internationally active financial institutions could stay abreast in an increasingly dynamic and interrelated global economy.

As to market dynamics, Board members noted that there was no unambiguous answer to the question of optimal design of risk control mechanisms that would strike a balance between the slow adjustment to shocks that has traditionally characterized relationship banking and the rapid adjustment that takes place in modern capital markets. Some Directors felt the key to avoiding the turbulence seen in the fall of 1998 was strengthening risk management and control procedures to avoid a buildup in excessive leverage. Others suggested that the mechanical and rigid use of risk management practices–together with frequent marking to market–might unnecessarily worsen financial market strains once a crisis had erupted, because of the speed with which they call for portfolio rebalancing and deleveraging.

Regarding macroprudential oversight, several Directors cited the need to better understand and monitor the complex nexus between monetary and financial policies—in particular, the role that abundant liquidity conditions might have played in the 1998 buildup of leverage. Several Directors called for greater attention to how the growth of global liquidity might be monitored and, more broadly, to its possible role in foreshadowing a buildup of leverage and imbalances–although a few Directors underscored the difficulty in defining and measuring such a concept. A number of Directors also wondered whether national authorities were adequately exploiting the synergies between macroprudential surveillance and the supervision of individual financial institutions. Several Directors suggested that more proactive and countercyclical prudential supervision and market surveillance could play a key role in helping avoid excessive leverage. Some Directors were concerned, however, noting the difficulty in appropriately timing any changes in capital adequacy ratios relative to the business cycle, as well as to divergences in business cycles around the world.

A number of Directors observed that, while improvements in the lines of defense (private sector risk management, banking supervision, and market surveillance) should help address the systemic issues associated with the highly leveraged institutions, they would not address concerns about the impact of such institutions on small and medium-sized markets. Several Directors therefore suggested that further work was needed to better understand the conditions under which the activities of highly leveraged institutions could destabilize small and medium-sized markets.

"Nonstandard" Policy Responses

A number of national authorities had resorted to relatively “nonstandard” responses to deal with extraordinary external pressures, including official intervention in bond and equity markets and the imposition or intensification of capital and foreign exchange controls. A number of Directors defended using such tools in the face of pressures seen as out of proportion to underlying fundamentals and given the aggressive tactics adopted by some investors. These Directors considered that such measures should not be ruled out in exceptional situations, to complement other policy adjustments. They recognized, however, that over the longer term, nonstandard official responses could negatively affect the risk-reward profile of various financial market investments. Other Directors suggested that the evidence on the efficacy and desirability of these interventions was at best inconclusive.

A number of Directors considered the capital controls that Malaysia adopted useful insurance against future speculative activity and believed that, in that sense, the controls had served their purpose. These Directors also argued that Malaysia had effectively used the protection provided by controls to continue restructuring its banking and corporate sectors. Some other Directors, however, noted that the use of controls might prove damaging to Malaysia’s longer-term interests and could deter future capital inflows. They thus urged other countries to use caution in adopting similar measures.

Credit Rating Agencies

The major credit rating agencies had become important providers of independent assessments of sovereign and private credit risks, Directors noted. The credit ratings issued by these agencies could have a strong impact on both the borrowers’ cost of funding and the willingness of major institutional investors to hold certain types of securities. Also, since the Basel Committee on Banking Supervision had proposed to make credit ratings a key determinant of the risk weights attached to bank exposures, many Directors believed that the influence of the credit rating agencies was likely to expand.

In view of the potential impact of rating changes on capital flows to emerging markets, a number of Directors were concerned about the performance of the major rating agencies before and during the recent emerging market crises. These agencies had introduced a procyclical element into global capital flows, contributing to the excessive capital flows into emerging markets, as well as to their abrupt reversals. Moreover, some Directors observed that the rating agencies failed either to give a warning of the crisis or accurately reflect economic fundamentals. Some Directors noted, however, that the lessons drawn by the credit rating agencies from their experiences were similar to those reached by the IMF staff for improving surveillance.

Several Directors expressed reservations about reliance on credit ratings, especially for sovereigns, in determining risk weights for bank lending. They noted that there was no clear track record regarding the accuracy of sovereign ratings and saw a clear need for the rating agencies to improve significantly the quality of their analysis—including by taking into account increased international interdependence and greater market complexities.