The strong world economic expansion of the past two years is losing momentum, due in large part to the effects of last summer’s run-up in oil prices and developments in the advanced industrial countries. In particular, the slowdown in the United States and the stalling recovery in Japan have increased the downside risks in the global economy. But it would be an exaggeration to embark on doomsday scenarios now. The recent reduction in key U.S. interest rates was a timely measure to help ensure a soft landing in the United States and strengthen global growth prospects. If necessary, the United States has further room to maneuver on both monetary and fiscal policy. In Europe, the fundamentals have improved and tax reforms are taking effect at the right time. But both Europe and Japan can and should do more to promote sustained growth and thereby strengthen investor confidence in the global economy. The key lies in deepening and accelerating structural reforms—with special attention to corporate and financial sector restructuring in Japan and to labor market and pension reform in Europe. Moreover, the broader international community would and should boost investor confidence, not least in the Asia region, by embarking on a new round of WTO negotiations designed to enhance free trade.
Exchange rate policy
Since the breakdown of the Bretton Woods system of fixed parities in the early 1970s, there has been widespread interest in exploring the scope for achieving greater stability in the exchange rates of the three major currencies. Since the introduction of the euro, there has also been renewed attention to proposals for the possible adoption of exchange rate target zones. We must recognize that the global environment is even less hospitable to such a system today than it was 25 years ago. Realistically, there is no alternative to floating exchange rates among the three major currencies.
However, this does not mean that the major industrial countries should practice benign neglect. The undervaluation of the euro (and corresponding overvaluation of the U.S. dollar) may have boosted European exports, but it has also posed problems—not least for emerging market countries of Asia and Latin America. The good news is that a reversal has been getting under way, thanks mainly to better economic performance in Europe and slowing growth in the United States. It was right for the European Central Bank to make clear that a heavily undervalued euro was unacceptable. Its interventions have demonstrated the ECB’s institutional maturity. Markets have taken note of this. But we also know that intervention cannot change market trends. Thus, intervention must be selective and, ultimately, well coordinated. Although it would be unwise to enter into formal commitments about particular exchange rate levels or ranges, the IMF’s largest member countries do have a responsibility to make the most of possibilities for effective policy coordination to reduce exchange rate volatility and risk of misalignments.
In the wake of the Asian crisis, many emerging market countries have adopted systems of managed floating. And a number of countries still maintain fixed exchange rates. Experience has shown that heavily managed or pegged exchange rate regimes can be tested suddenly by exchange markets and that it can be costly either to defend them or to exit under disorderly circumstances. On balance, we have a responsibility to advise our members that while such regimes can succeed, the requirements for a country to maintain a pegged or heavily managed exchange rate are daunting—especially when the country is strongly engaged with international capital markets. There is essentially no room for error. Countries opting for such a system must pursue, unwaveringly, sound macroeconomic policies and be fully aware of the associated costs, including that extraordinarily high interest rates might be required at times of severe financial market pressure. Moreover, their domestic financial institutions and businesses must be well prepared to live with such policy adjustments.
On balance, a floating rate system is more forgiving of policy errors and therefore a somewhat safer solution for most countries. I do not mean a system in which the authorities are indifferent to the behavior of the exchange rate; indeed, it may at times be appropriate to adjust monetary policy in response to external developments. But with a floating rate, there is no need to risk unsustainable drains on its foreign exchange reserves to defend an exchange rate target. Moreover, a country can pursue a more independent monetary policy while receiving important signals from the exchange markets about the soundness of its policy framework. To be sure, floating is no panacea. It requires an alternative anchor for monetary policy and inflation expectations, such as inflation targeting. And countries can still face difficult choices, especially if they are faced with large swings in international capital flows. Still, the absence of an exchange rate target provides an important, extra degree of freedom for domestic policy management and dealing with external shocks.
The IMF’s largest member countries do have a responsibility to make the most of possibilities for effective policy coordination to reduce exchange rate volatility.
Controls and capital account liberalization
We should not be surprised that the recent financial crises in emerging markets have led to renewed examination of the merits of capital controls. The earlier experience in Chile, for instance, confirmed that judicious use of controls on short-term inflows can help to avoid an excessive buildup of short-term debt. In Malaysia, which adopted controls on capital outflows in the context of the Asian financial crisis, the evidence is not clear. In some other countries, the effect of capital controls has been clearly negative. In particular, when controls are used as a substitute for necessary adjustment or institutional development, they reduce a country’s growth potential, create incentives for corruption and evasion, and impede access to foreign capital without addressing the underlying economic vulnerabilities. For this reason, even controls on short-term inflows should be used in support of sound policies, and in conjunction with an exit strategy and timetable for their removal. Given the mixed experience to date, I see a need for further research and analysis to assess the costs and benefits of capital controls in particular circumstances. Still, there should be no confusion: in my view, integration into the global economy is challenging, but, over the long run, it clearly provides better prospects for growth and prosperity.
In particular, the benefits of carefully prepared integration into the global financial system outweigh the risks. But we should also draw a lesson from the recent crises in emerging markets that, in some cases, there was clearly overly rapid capital account liberalization. Coping safely with volatile international capital flows requires sound domestic financial systems, adequate supervision and prudential regulation, and good risk-management capacities in banks and businesses, reinforced by greater transparency and market discipline. It is important to put these preconditions in place, insofar as possible, before the capital account is fully opened. Thus, in some cases, the transition may need to be gradual. The IMF staff will be reviewing the experience in a number of country cases to begin distilling more detailed, practical suggestions on sequencing.
Regional cooperation and integration can play a very significant role in helping countries become successfully integrated into the global trade and financial systems. Regional cooperation in Asia has recently gained new momentum as a way to cope with the challenges of globalization. I find this quite natural and positive. Through the Chiang Mai initiative [March 25,2000], the ASEAN+3 countries [the members of the Association of Southeast Asian Nations, plus China, Japan, and Korea] have proposed strengthening regional financial cooperation through an expanded network of swap facilities. I welcome this initiative and encourage the ASEAN+3 countries to make it operative. I understand it as a complement to the IMF’s financial assistance for members in the region that undertake adjustment efforts, and look forward to defining the modalities for our cooperation on this important matter.
European Economic and Monetary Union
The European Union represents a far-reaching process of regional integration. At the outset, it was guided by strong political considerations—especially by the desire to promote peace and stability in a region devastated by the Second World War.
There can be no doubt that this process has helped to create wealth and stability in Europe. But the turbulence in the European Exchange Rate Mechanism in 1992 and 1993—which led the United Kingdom to leave the system and made it necessary to widen the exchange rate band of this system of fixed but adjustable exchange rates—served as a powerful reminder that progressive monetary integration needs to build on strong convergence of national economic policies and performance. I still believe that monetary union in Europe must be underpinned, in the long run, by some form of political union—where the members are prepared to act together on a wider range of policies. The process of integration in Europe obviously has not yet ended, and its final outcome is still to be determined. In this context, the recent European summit in Nice was another step forward. But it also highlighted the need to clarify further the nature of European integration.
I am not here to suggest that the European experience is a model that Asia can and should copy. Regional developments in Asia should be driven by its own political dynamics and unique historical background. But trading patterns and geography do make it reasonable to think of the creation of an internal market in Asia as a possible future stage in regional cooperation. And why should this not be a basis for greater monetary integration if that is what the people of Asia desire?
Photo credits: Toshifumi Kitamura for AFP, page 21; Eriko Suita for Reuters, page 24; Denio Zara, Padraic Hughes, Pedro Márquez, and Michael Spilotro for the IMF, pages 25𠄓29, 33, and 36.