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Economic Surveillance And Crisis Prevention: Promoting Healthy Economies

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
August 2006
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The main job of the IMF is to promote international monetary cooperation and economic and financial stability in member countries and at the global level as a basis for sustained economic growth, which is essential for raising living standards and reducing poverty. Promoting macroeconomic and financial stability is partly a matter of avoiding economic and financial crisis, which can destroy jobs, slash incomes, and cause great human suffering. But it is also a matter of avoiding large swings in economic activity, high inflation, and excessive volatility in exchange rates and financial markets. Any of these types of instability can increase uncertainty and discourage investment, impede economic growth, and erode living standards.

A dynamic market economy necessarily involves some degree of instability, as well as gradual structural change. The challenge for policymakers is to minimize instability without hampering the ability of the economic system to raise living standards through higher productivity, efficiency, and employment.

New shopping malls, similar to this one in Andhra Pradesh, are sprouting up across India.

Experience has shown that the countries with the strongest growth and employment rates and the least economic instability are those that follow sound macroeconomic (fiscal, monetary, and exchange rate) policies; allow markets to function, with appropriate regulatory, structural, and social safety net policies; are open to international trade; build strong economic policymaking and regulatory institutions; foster the development of strong financial systems; collect, monitor, and disseminate high-quality data; and embrace good governance.

The IMF promotes the stability of the international financial system through its three primary functions:

Surveillance. The IMF is responsible for overseeing the international monetary system and the compliance of each member country with its obligations to pursue policies conducive to orderly growth and price stability, help promote stable exchange arrangements and avoid exchange rate manipulation, and provide the IMF with data about its economy. The IMF exercises this responsibility by tracking economic and financial conditions around the world and examining whether policies in member countries are appropriate from the international as well as the national point of view. It alerts member countries to impending dangers, enabling governments to take preventive action.

Lending. The IMF lends to countries with balance of payments difficulties. The primary objectives of its lending to low-income countries are economic growth and poverty reduction.

Technical assistance and training. The IMF helps member governments develop strong policymaking institutions and economic policy instruments.

Surveillance in action

With its nearly universal membership, the IMF serves as an international forum where members can discuss developments in their respective economies and in the global economy. In recent decades, a major challenge to economic and financial stability has come from the growth in the size and sophistication of international capital markets. In many ways, financial globalization is a welcome development. It provides opportunities to channel private capital flows to finance investment and growth in countries where this capital can be used most productively. Capital market integration, in principle, enables countries to adjust to external shocks without having to rely on official funds.

But capital flows are also a potential source of volatility, especially in many emerging market countries. A new breed of crisis—arising from sudden capital outflows—has proved harder to manage than the current account imbalances that the IMF traditionally dealt with in its lending activities. Arresting an outflow of capital requires measures that restore investor confidence, including, in some cases, financial help from international institutions.

Financial globalization has also increased the risk of contagion by introducing new channels—in addition to the traditional trade links—through which one country’s problems can affect others and even spread through the global economic system.

Current trends suggest that economic and financial globalization will continue to intensify, and emerging markets are likely to represent a growing share of the world economy. The nascent emerging market giants, India and China, are of particular systemic importance. And the aging of industrial country populations, by shifting saving-investment balances internationally, may stimulate larger cross-border capital flows.

To keep a close watch on these developments, the IMF is continuing to strengthen its analysis and advice through more tightly focused surveillance, deeper scrutiny of exchange rate issues, and better analysis of financial sectors, debt sustainability, and regional and global spillovers. To strengthen its financial and capital market work, the IMF has taken a number of steps (see box on page 18), including the merging of its activities in these areas in a new department that will be a center of excellence for all aspects of financial, capital market, and monetary work at the IMF The increased attention to financial sector work and its closer integration with the IMF’s macroeconomic analysis is a cornerstone of the Managing Director’s Medium-Term Strategy (see page 7).

Types of surveillance

Country. The IMF holds consultations, normally once a year, with each member country about its economic policies. These “Article IV consultations,” which are required under the IMF’s Articles of Agreement, focus on the member’s exchange rate, fiscal, and monetary policies; developments in its balance of payments and external debt; the influence of the country’s policies on its external accounts; the international and regional implications of its policies; and the identification of potential vulnerabilities.

As financial markets around the world have become more integrated, IMF surveillance has become increasingly focused on capital account, financial, and banking sector issues. Institutional issues, such as central bank independence, financial sector regulation, corporate governance, and policy transparency and accountability, have also become more important to IMF surveillance in the wake of financial crises in emerging market countries and in the context of member countries making the transition from planned to market economies.

Regional. To supplement country consultations, the IMF examines policies pursued under regional arrangements, such as in the Central African Monetary and Economic Union, the Eastern Caribbean Currency Union, the Euro Area, and the West African Economic and Monetary Union. In addition, the IMF is paying more attention to issues of common interest to countries in given regions (for example, in Central America, the Middle East, Pacific Island countries, and sub-Saharan Africa). The discussions of staff reports on these topics allow not only consideration of policies decided at the regional level but also comparative analysis of developments and policies across a region, and analysis of the regional transmission of shocks. Over the past few years, the IMF has also begun to publish its main findings on regional surveillance in semiannual Regional Economic Outlook reports.

Global. In addition to country and regional surveillance, the IMF monitors global economic conditions, countries’ economic policies in the global context, and developments in international capital markets. In this surveillance work, the IMF also assesses the global effects of major economic and financial developments, including in such areas as oil markets and trade. Its main findings are published twice a year in the World Economic Outlook and the Global Financial Stability Report, which serve as documentation for the discussions of the IMFC.

The April 2006 World Economic Outlook report welcomed a continued strong expansion of the global economy, noting that the expansion had exceeded expectations and become more broad based. The April 2006 Global Financial Stability Report, meanwhile, cited the increased resilience of the global financial system but also underscored that larger global imbalances posed continuing risks, as did higher debt levels, notably in the household sector.

In addition to these semiannual reviews, the Executive Board holds frequent informal discussions of world economic and market developments. IMF management and senior staff also take park in discussions on the economic outlook and policies among finance ministers, central bank governors, their deputies, and other officials in a variety of groups and forums, such as the Group of Eight (G8) major industrial countries, the Group of 24 (G24) developing countries, and the Financial Stability Forum.

Taking early action

Early warning of an impending crisis is not enough to prevent the crisis; prompt preventive action is also necessary. Moreover, with increasing economic and financial integration and the risk of contagion and spillovers, surveillance must focus not just on crisis-prone countries but also on the system as a whole. The IMF, as the impartial voice of the international community, has a particularly important role to play in highlighting major economic challenges that the world has to tackle. It was in recognition of this unique role that the IMF was called upon at the 2006 spring meeting of the IMFC, to take new steps, including multilateral consultations, to encourage actions to redress global imbalances. The IMF Managing Director said that this would mean the IMF would provide a framework in which governments would engage in an active consultation process on the consequences of actions and inactions.

Lessons from crises in the 1990s had earlier prompted the IMF to take significant steps to sharpen the focus of its surveillance on crisis prevention. These measures included bolstering its regional and global surveillance and advising its members to incorporate more “shock absorbers” into their policies—such as fiscal policies that achieve consolidation during good times and provide room for easing in difficult times, adequate reserve levels, efficient and diversified financial systems, exchange rate flexibility, and more effective social safety nets. And it has introduced several specific initiatives that seek to make countries less vulnerable to crisis:

  • In 1999, partly in response to the Asian crisis, the IMF and the World Bank introduced the Financial Sector Assessment Program (FSAP), which provides comprehensive evaluations of countries’ financial sectors. FSAP reports help countries identify the strengths, risks, and vulnerabilities of their financial systems and formulate appropriate policy responses. The IMF also assesses offshore financial centers, which account for a sizable portion of the world’s financial flows and thus are potentially important for global financial stability In addition, the IMF is involved in international efforts to combat money laundering and the financing of terrorism.

  • The IMF has developed and actively promotes standards and codes of good practice in economic policymaking. In the area of data standards, it has designed initiatives to enhance public availability of reliable, timely, and comprehensive statistics on member countries, helping market participants make well-informed investment decisions and reducing the likelihood of shocks that can precipitate crises.

  • The IMF has improved its analytical framework for identifying countries’ vulnerabilities to crisis, including through assessments of balance sheet vulnerabilities, debt sustainability and liquidity management, and the monitoring of financial soundness indicators. These analyses aim to strengthen the IMF’s policy advice to member countries on how to make their economies more resilient to shocks and to help countries judge whether they can service their external and public debts over time without an unrealistically large correction to the balance of income and expenditure.

  • The IMF has increased efforts to promote good governance, which is essential for strong economic performance. Particular areas of emphasis include improving the efficiency and accountability of public sectors and financial systems.

  • The IMF has stepped up its attention to trade-related vulnerabilities, which remain a pressing issue for the poorest countries with IMF-supported programs. To help developing countries address the short-term effects on their balance of payments of multilateral trade liberalization, the IMF’s Trade Integration Mechanism makes resources more predictably available to qualifying member countries under existing IMF facilities.

  • To support low-income countries that do not want—or need—IMF financial assistance, the IMF introduced, in October 2005, the Policy Support Instrument (PSI). The PSI helps countries design effective economic programs and allows them to demonstrate their commitment to sound policies either for domestic purposes or as a signal to international creditors and donors.

  • Also under consideration—to help the IMF respond to the new challenges and needs of emerging market members—is a new instrument to provide high-access contingent financing for countries that have strong macroeconomic policies, sustainable debt, and transparent reporting, but remain vulnerable to shocks.

Transparency at the IMF

The IMF has also focused on improving its own accountability by establishing in 2001 the Independent Evaluation Office (see page 32) and by increasing over the past decade the transparency of its operations and decision making. The IMF has become a more open and accountable institution and a major source of information for the general public and capital market participants while preserving its role as confidential advisor to its member countries.

The IMF now publishes most policy papers written for the Executive Board and posts financial and operational information on its website. It also makes available more information about its oversight of members’ policies and their IMF-supported programs. Although publication of documents related to member countries requires the consent of the relevant member country, there is, in most cases, a presumption of publication, and the large majority of staff reports are published.

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