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, 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 1.2

Key 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.

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

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Equity Market Performance

(May 2003 = 100)

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Sovereign Spreads

(In basis points)

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

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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

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.

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.

Japan

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

Japan-IMF activities in FY2004

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

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Japan-IMF activities in FY2004

August 2003	Completion of Article IV consultation by the Fund’s Executive Board
September 2003	Publication of Financial System Stability Assessment and supplementary information
February 2004	Visit 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

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

Mozambique-IMF activities in FY2004

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

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Mozambique-IMF activities in FY2004

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