Chapter 2. Surveillance Over Members’ Economic Policies
- Parmeshwar Ramlogan, and Bernhard Fritz-Krockow
- Published Date:
- April 2007
Surveillance in the Articles of Agreement
The Articles of Agreement set out the obligations of member countries and the IMF, which form the legal basis of IMF surveillance over members’ economic policies.10 The core article in this respect is Article IV of the IMF’s Articles of Agreement. The principles and procedures of surveillance were set out in further detail in a 1977 Executive Board Decision, which established how surveillance would be conducted after the adoption of the Second Amendment to the Articles.*
Article IV of the IMF’s Articles of Agreement
Article IV is the core article outlining the members’ and the IMF’s responsibilities in surveillance.
Section 1 requires member countries to pursue economic policies consistent with the IMF’s purpose, and stipulates that “each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates.” In addition to this general undertaking to collaborate with the IMF and other members, Section 1 identifies four specific obligations for members. Each member is required to:
Endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability.
Seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions.
Avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.
Follow exchange policies compatible with the undertakings of Article IV, Section 1.
Section 2 allows members to set the exchange rate arrangements of their choice, with the exception of arrangements that would set gold as a value denominator. It requires members to notify the IMF promptly of these arrangements and any changes to them.
Section 3 (a) empowers the IMF to “oversee the international monetary system in order to ensure its effective operation” and to “oversee the compliance of each member with its obligations under Section 1 of this Article.”
Section 3 (b) states that, in order to fulfill its functions under Section 3 (a), the IMF “shall exercise firm surveillance over the exchange rate policies of members, and shall adopt specific principles for the guidance of all members with respect to those policies.” Furthermore, “Each member shall provide the Fund with the information necessary for such surveillance, and, when requested by the Fund, shall consult with it on the member’s exchange rate policies.”
The 1977 Decision on Surveillance over Exchange Rate Policies adopted principles for the guidance of members on their exchange rate policies, and principles of IMF surveillance providing guidance to the IMF in monitoring the observance by members of these principles through the specification of indicators.
The IMF relies upon the information provided by the members to conduct its surveillance under Article IV. In this context, Article VIII, Section 5 of the IMF’s Articles of Agreement stipulates that the IMF may require members to furnish it with information as it deems necessary for its activities (including surveillance), and specifies a list of data that the IMF deems the minimum necessary to conduct its duties.
The list includes data relating to the central government, the balance of payments, external reserves, exchange controls, the international investment position, national accounts, prices, the central bank, and the banking system.11
The term “surveillance” refers to bilateral surveillance that is conducted pursuant to Article IV and is mandatory for all members. Some activities associated with surveillance, such as the multilateral surveillance exercises initiated in 2006, the Financial Sector Assessment Program (FSAP), and the work on standards and codes, are voluntary arrangements between member countries and the IMF (see Chapter 7). These activities are not mandatory for countries and have been developed in recent years to strengthen surveillance. Nevertheless, they are often included under the general term of “surveillance”—for example, the FSAP is referred to as “financial sector surveillance.” For this reason, when speaking of members’ obligations under the Articles of Agreement, surveillance is usually referred to as “Article IV surveillance.”
Articles VIII and XIV of the IMF’s Articles of Agreement
The IMF, within the context of an Article IV consultation, often addresses issues that fall outside the scope of surveillance entirely and are beyond its oversight of a member’s compliance with the obligations specified under Article IV, Section 1. For example, as explained in the section on modalities of surveillance, the IMF uses the occasion of an Article IV consultation to consult with members with respect to the retention of exchange restrictions under Articles VIII and XIV. These Article VIII and XIV consultations are “comprehended” by the Article IV consultation but they do not form part of the Article IV consultation. They are legally different from the IMF surveillance activities and serve different purposes.
Article VIII, Sections 2, 3, and 4, provides the legal basis for the member countries’ obligations to maintain currency convertibility and exchange regimes free of restrictions or discriminatory practices, and to provide adequate information.
Section 2 prohibits members from imposing restrictions on the making of payments and transfers for current international transactions without the approval of the IMF. The IMF will only approve restrictions if it is satisfied that they are necessary for balance of payments purposes, and that their use will be temporary, and that they are not discriminatory, while the member is seeking to eliminate the need for them.12
Section 3 prohibits members from engaging in any discriminatory currency arrangements or multiple currency practices except as authorized under the Articles of Agreement or approved by the IMF. Members maintaining such arrangements or practices are expected to consult with the IMF as to their progressive removal, unless they are maintained or imposed under the Article XIV, Section 2.
Section 4 requires members to maintain the convertibility of their currency, by buying balances of their currency held by other members when requested by these other members.
Article XIV provides transitional arrangements for countries that have not yet accepted the obligations under Article VIII.
Section 1 requires members to notify the IMF upon joining whether they intend to avail themselves of the transitional arrangements in Section 2 of this Article, or whether they are prepared to accept the obligations of Article VIII, Sections 2, 3, and 4.
Section 2 permits members to maintain and adapt to changing circumstances the restrictions on payments and transfers for current international transactions that were in effect on the date on which they became members. However, members are expected to withdraw restrictions maintained under this Section, and to accept the obligations under Article VIII, Sections 2, 3, and 4, as soon as balance of payments conditions permit.
Section 3 stipulates that the IMF shall make annual reports on the restrictions in force under Section 2 of this Article. Any member retaining any restrictions inconsistent with Article VIII, Sections 2, 3, and 4 is required to consult annually with the IMF as to their further retention.
Characteristics of Surveillance
Bilateral surveillance under Article IV is mandatory for all member countries. Furthermore, according to the 1977 surveillance decision, the principles and procedures that guide surveillance apply “to all member countries whatever their exchange arrangements and whatever their balance of payments position.”13 Surveillance consultations are held routinely with every IMF member country, irrespective of their level of development or the strength or weakness of their economic policies.
Uniformity of Treatment
The Executive Board has at various times stressed the importance of maintaining the uniformity of treatment of member countries.14 This principle applies to all IMF activities, and not just to the conduct of surveillance. It requires that members in similar circumstances be treated similarly.
Article 3 (b) states that surveillance principles “shall respect the domestic social and political policies of members, and in applying these principles the Fund shall pay due regard to the circumstances of members.” The 1977 Decision on Surveillance over Exchange Rate policies also provides that the surveillance of exchange rate policies shall be adapted to the needs of international adjustment as they develop, while the 2002 biennial review reiterated its support for flexibility in surveillance procedures, emphasizing that coverage of surveillance should be molded to country-specific circumstances.15
Flexibility is applied in two ways. First, there have been changes in the breadth, depth, and intensity of surveillance over the years in response to new challenges and demands in the global economy, to new research findings on relevant policy issues, and to the need to better manage staff and Executive Board resources. Second, the conduct of surveillance varies with individual country circumstances—for example, with respect to timing, frequency, and focus of consultations with members.
Although the conduct of bilateral surveillance is an obligation for both the IMF and the members, the IMF seeks to work in a cooperative spirit with member countries, based on mutual trust and confidence. The Executive Board has repeatedly expressed strong support for the cooperative approaches underlying the IMF’s relations with members.16 The IMF recognizes that the success of surveillance depends in part on the extent to which member countries implement its advice, and that implementation will be more likely if members “own” the policies that IMF staff recommend. Thus it emphasizes, among other things, effective communication and close policy dialogue with countries, including with legislative bodies, in order to enhance ownership. In addition, some of the IMF’s monitoring activities, such as the financial sector assessment program and the work on standards and codes, rely on the voluntary participation of members.
The effectiveness of surveillance depends crucially, among other things, on sound policy advice based on accurate analysis of a country’s economic problems and challenges. The IMF recognizes that the quality of its analysis and advice depends in part on complete frankness by IMF staff in the surveillance exercise. At the 2002 biennial review, the Executive Board stressed the importance of candid staff reports and summings up to convey clear and strong messages to member governments on required policy actions. During the discussion of the IMF’s transparency policy in June 2005 the Board again emphasized that candor in the IMF’s dialogue with members and in reporting to the Board remains essential for effective surveillance.17 Also, the Board stressed in 2004 that a thorough and candid discussion of exchange rate issues remains critical for surveillance.18 However, under the IMF’s policy for deletions and corrections, market-sensitive information in staff reports may be deleted prior to publication of the reports, at the request of the member country.
Comprehensiveness is understood to mean coverage of all policies that are relevant for macroeconomic performance. The 1977 surveillance decision states: “The Fund’s appraisal of a member’s exchange rate policies shall … be made within the framework of a comprehensive analysis of the general economic situation and economic policy strategy of the member….” This statement reflects the understanding that exchange rate developments are closely linked to the broad policy regime of the country.
Over the years, the scope of surveillance has expanded from a relatively narrow focus on fiscal, monetary, and exchange rate policies to a broader purview encompassing external vulnerability assessments, external debt sustainability analyses, and financial sector vulnerabilities, which have an impact on macroeconomic conditions. The increased focus on these issues was particularly noticeable after the Asian crises of the mid-1990s, when the IMF stepped up its crisis prevention efforts. This broader coverage constitutes a necessary and positive adaptation of surveillance to a changing global environment—most notably to the rapid expansion of international capital flows—and to the recognition that structural factors are important determinants of economic performance. At the same time, the IMF has reduced the scope of surveillance by limiting the analysis of other structural and institutional policies that could have an impact on macroeconomic conditions.
The IMF does not always have the expertise or experience necessary to cover all issues that may at times be critical to a country’s macroeconomic stability. On such issues, the IMF would normally draw on the expertise of other institutions, such as the World Bank, regional development banks, or specialized agencies.
A careful balance needs to be maintained between comprehensiveness and focus. This is done first by ensuring that coverage is adapted to country-specific circumstances. Also, there are two closely-related criteria to guide the selection of issues to be covered in the Fund’s consultations with member countries: macroeconomic relevance and the IMF’s hierarchy of surveillance concerns:
Macroeconomic relevance. The macroeconomic relevance criterion is that policy issues should be covered in surveillance discussions only when they have a sizeable influence on macroeconomic developments.
Hierarchy of surveillance concerns. Within the range of macroeconomically-relevant issues, there is a hierarchy of surveillance concerns. Matters that would be given prominent attention are: external sustainability; vulnerability to balance of payments or currency crises; sustainable economic growth with price stability; and, for systemically-important countries, conditions and policies affecting the global or regional economic outlook.19
Modalities of Surveillance
IMF surveillance takes three forms: bilateral, regional, and multilateral. Bilateral surveillance traditionally has been one of the core surveillance activities. However, regional and multilateral surveillance have assumed greater importance in recent years, as the need for more systematic treatment of contagion and cross-country themes in bilateral surveillance became obvious following the Mexican crisis. This has been accompanied by more reporting to the Executive Board on regional and multilateral developments as the backdrop for bilateral consultations. Regional and multilateral surveillance help strengthen the effectiveness of the IMF’s bilateral surveillance.
Article IV Consultations
Article IV consultations are the principal tool of bilateral surveillance. They involve bilateral discussions between the IMF and individual member countries. They begin with a mission of IMF staff to the country to gather information and conduct discussions with country officials. Missions normally last two to three weeks and discussions are held primarily with government officials. The mission also tries to meet with representatives from the private sector, labor unions, non-government organizations, regional organizations, or academia. The objective is for the staff to gain as wide a perspective as possible on the country’s economic situation and vulnerabilities.
At the end of the mission, final discussions are held with the authorities to present the missions’ preliminary findings on developments, vulnerabilities, outlooks, and recommendations. A member of the Executive Director’s office would normally attend these discussions. The staff might also leave with the authorities a statement summarizing its findings. Upon return to headquarters, the staff writes a report setting out recent developments, the policy discussions, the short- and medium-term outlook, and the staff’s appraisal of the country’s economic situation and the authorities’ policy stance.
The staff report, supplemented by a “buff” statement by the Executive Director to amplify the country’s perspective on the issues involved, forms the basis for an Executive Board discussion.* This discussion normally takes within place 65 days of the mission’s return to headquarters (or three months for members eligible for the Poverty Reduction and Growth Facility).20
The Executive Director representing the country takes an important part in the Board discussion, clarifying points about the country’s economy and its policies as necessary. The Board discussion concludes the Article IV consultation and initiates the next consultation cycle (Box 2.1). The summing up of the Board discussion is transmitted to the country’s authorities and, if the authorities agree, is published in a Public Information Notice (PIN).
Box 2.1.Article IV Consultation Cycles
The Standard 12-Month Consultation Cycle
The standard Article IV consultation cycle is one year. This means that Board conclusion of the consultation must normally take place within one year of the date of conclusion of the last consultation, though there is a grace period of three months. Delays beyond the 15-month period must be approved by the Board. Such approvals are granted based on staff justification of the delay.
Non-program countries are expected to be on the 12-month consultation cycle if they satisfy one or more of the following criteria: (i) they are of systemic or regional importance; (ii) they have completed an IMF arrangement in the past year; (iii) they have outstanding IMF credit above 25 percent of quota; and (iv) they are potentially subject to risk because of policy imbalances or exogenous developments, or they have pressing policy issues of broad interest to the IMF membership. However, the Executive Board, recognizing the need for flexibility in the context of strains on staff resources, has allowed for longer consultation cycles, not exceeding 24 months, for non-program countries that do not satisfy these criteria. Countries have to agree to move to a longer consultation cycle, and there may be interim staff visits.
Consultation Cycle for Program Countries
Member countries receiving financial assistance under an IMF arrangement or member countries benefiting from a Policy Support Instrument (PSI) move automatically to a 24-month consultation cycle. This is done to reduce the strain on staff resources, and in recognition that the Board is kept routinely informed of developments in program countries through periodic program reviews. However, the consultation cycle is shortened under the following circumstances:
Where the most recent Article IV consultation was concluded 6 months or more before the date of approval of an arrangement or PSI, the next Article IV consultation should be completed within (i) 6 months of the date of approval of the arrangement or PSI, or (ii) 12 months, plus a grace period of three months, of the date of completion of the previous Article IV consultation, whichever is later.
Where a program review is delayed, the next Article IV consultation should be completed within (i) 6 months of the original date of completion of the review, or (ii) 12 months, plus a grace period of three months, of the date of completion of the previous Article IV consultation, whichever is later. However, if the review is completed before the later of these two dates, the next Article IV consultation should be completed within 24 months of the date of completion of the previous Article IV consultation.
Upon the expiration or cancellation of an arrangement or termination of a PSI, the next Article IV consultation should be concluded within (i) 6 months of the date of expiration, cancellation, or termination, or (ii) 12 months, plus a grace period of three months, of the date of completion of the previous Article IV consultation, whichever is later, but not more than 24 months after the completion of the previous Article IV consultation, after which the country reverts to the standard 12-month consultation cycle.
The 24- Months Consultation Cycle for Non-Program Countries
Non-program countries can be on a 24-month consultation cycle if they satisfy the following criteria: (i) they are not of systemic or regional importance; (ii) they have not completed an IMF-supported arrangement in the past year; (iii) they have outstanding IMF credit under 25 percent of quota; and (iv) they are not potentially subject to risk because of policy imbalances or exogenous developments, or they do not have pressing policy issues of broad interest to the IMF membership. Countries have to agree to move to a longer consultation cycle, and there may be interim staff visits.
Article XIV and Article VIII Consultations
The IMF conducts annual consultations with countries that maintain exchange restrictions under the transitional arrangements under Article XIV of the Articles of Agreement as to their further retention. Members are strongly encouraged to accept the obligations of Article VIII, Sections 2, 3, and 4 when the exchange restrictions are deemed to be no longer justified. However, before members notify the IMF that they are accepting the obligations of Article VIII, Sections 2, 3, and 4 it is desirable that they eliminate the exchange measures which would require the approval of the IMF under Article VIII, Section 2 (a) and 3, and that they satisfy themselves that they are not likely to need recourse to such measures in the foreseeable future.
As noted earlier, Article XIV and Article VIII consultations are normally “comprehended” in Article IV consultations. Staff findings and recommendations regarding restrictions maintained under Article XIV and subject to Article VIII Sections 2 and 3 are set out in the staff report for the Article IV consultation, and the consultations are normally concluded together with the Article IV consultation. However, Article XIV consultations are required to be concluded every 12 months. Thus, in the event that the Article IV consultation is to be concluded beyond the 12 month period, the Article XIV (and Article VIII consultations) must be concluded independently. This is normally done by the Executive Board on a lapse-of-time basis.
Multilateral surveillance plays an important role in the IMF’s efforts to strengthen surveillance, by detecting and heightening awareness of systemic risks and inter-dependencies in the global economy. It reviews developments in the global economy and financial markets and the outlook, highlighting the spillover effects of policy changes in systemically-important countries. As part of its multilateral surveillance efforts, the IMF is working to strengthen its effectiveness as a global forum for discussion of economic inter-linkages among countries.
Multilateral consultations, the World Economic Outlook report, the global financial market surveillance reports, and the Annual Review of Exchange Arrangements and Exchange Restrictions (AREAER) are key instruments for multilateral surveillance:
Multilateral consultation. This form of consultation was introduced in 2006 as part of the IMF’s Medium-Term Strategy and is expected to take a more defined role over time.21 Each multilateral consultation is intended to focus on a specific international economic or financial issue and directly involves selected countries that are a major party to that issue. The consultation aims at facilitating a policy dialogue among members when a collaborative solution may be required. Focusing on cooperative action, the multilateral consultation is complementary to the bilateral Article IV consultations. These consultations do not oversee members’ compliance with their obligations under Article IV, and the staff discusses issues of multilateral surveillance with the key parties both individually and jointly. The associated staff report is discussed by the Executive Board and by the IMFC.
World Economic Outlook (WEO). This report is the primary vehicle for surveillance of global economic developments and prospects. It is prepared and published twice-yearly by the Research Department, in the spring and autumn, as background information for the meetings of the IMFC, but on occasion is produced more frequently when rapid changes in the world economy warrant. Its preparation is a cooperative effort with other departments, particularly the area departments. The WEO report offers a comprehensive analysis of prospects and policies for the world economy, major regions, and individual countries, including forecasts of global macroeconomic variables and commodity price trends. Each report also contains staff studies of topical issues relevant to the global economy. WEO report forecasts are based on country-by-country forecasts from area departments and also constitute an important input into the work of the area departments.
Global Financial Stability Report(GFSR): This is the main instrument of global financial market surveillance. The GFSR is prepared and published semi-annually, providing timely and comprehensive coverage of both mature and emerging financial markets. Its main objectives are to identify potential vulnerabilities in the international financial system from a multilateral perspective and to analyze linkages between developments in mature financial centers and capital flows to emerging markets. Through the Capital Markets Consultative Group, the staff maintains a dialogue with representatives of internationally-active private financial institutions on issues such as the development of investor relations programs or the promotion of standards and codes.
The WEO and GFSR reports are supplemented with regular informal Board sessions on world economic and market developments (WEMD) and financial market updates. These sessions typically provide an update on recent developments, the near-term outlook, and policy implications.22
Annual Review of Exchange Arrangements and Exchange Restrictions(AREAER). This is prepared in consultation with national authorities on the basis of data they provide. The publication includes information on the exchange rate and foreign trade regimes, and exchange controls of countries. In addition, the biannual review of exchange arrangements and exchange restrictions, which is based on the AREAER data, provides analysis of the latest developments and trends in exchange rate regimes and exchange controls on both current international and capital account transactions.
Surveillance is also undertaken of regional developments and policies pursued by supra-national authorities. It complements bilateral Article IV consultation discussions with individual member countries by providing a regional dimension to country policy issues, and there is increasing integration of the two. Regional surveillance is particularly relevant for members of currency unions, for which policies in key areas of IMF surveillance are determined at the regional level. Discussions with regional authorities are coordinated with Article IV discussions with country officials, while staff reports on the regional discussions are considered by the Executive Board separately or together with the Article IV reports.
Formal procedures exist for conducting surveillance over the monetary and exchange rate policies of the euro area, reflecting the systemic importance of the region.23 These involve twice-yearly discussions with EU institutions responsible for common policies in the euro area. Such discussions are held separately from the discussions with individual countries, but are considered an integral part of the Article IV surveillance for individual countries. The discussions with individual euro area countries are clustered as much as possible around the regional discussions, which cover monetary and exchange rate policies as well as, from a regional perspective, other economic policies relevant for IMF surveillance. There is an annual staff report and Executive Board discussion on euro area policies in the context of the Article IV consultations with member countries. A summing up of the Board discussion is produced, which is cross-referenced in the summings up for the bilateral Article IV consultations with individual euro-area countries and, if relevant, in the bilateral consultations with EU member countries that are not part of the euro area.
Formal discussions at the regional level are also held with the three other currency unions—the West African Economic and Monetary Union (WAEMU), the Central African Economic and Monetary Community (CEMAC), and the East Caribbean Currency Union (ECCU)—in addition to the bilateral consultations with the member countries of these groups. A formal regional surveillance procedure has been established for these discussions, similar to that for the euro area. Annual regional reports are prepared by the staff and discussed by the Executive Board, and a summing up of the Board discussion is produced. The coverage of regional discussions with these currency unions is broadly comparable to that of the euro area.24
Regional surveillance outside the currency unions encompasses the regular regional outlook documents and other notes, the maintenance of a dialogue with various regional fora, and research on regional issues. Most of these activities are conducted informally. The results feed into IMF’s bilateral surveillance through information sharing, strengthened policy analysis, and enhanced policy outreach. In Asia, in addition to the regional office in Tokyo, the IMF has been designated as the technical secretariat of the Manila Framework Group that was established specifically to undertake macroeconomic surveillance. The IMF also maintains dialogues with the Association of South East Asian Nations (ASEAN) and the Gulf Cooperation Council (GCC).
Strengthening Surveillance to Prevent Financial Crises
As noted above, external sustainability and vulnerability to balance of payments or currency crises constitute the zenith of the IMF’s surveillance concerns. In recent years the IMF has strengthened its surveillance efforts to deal with these concerns. A number of initiatives have been taken to enhance the effectiveness of bilateral surveillance and crisis prevention. These initiatives include external vulnerability assessments, strengthening financial sector surveillance (including the Financial Sector Assessment Program, combating money laundering and terrorism financing, and offshore financial center assessments), improving data provision to the IMF, and re-examining surveillance in program countries, all of which are discussed in the remainder of this section. The increased emphasis on regional and multilateral surveillance to monitor and analyze cross-border transmission of macroeconomic risks is part of these efforts. Other initiatives, including those to strengthen international standards and codes, are explained in Chapter 7. Ongoing efforts to strengthen and focus surveillance will be put in place within the framework of the IMF’s Medium-Term Strategy.
External Vulnerability Assessments
The IMF has incorporated vulnerability assessments in its surveillance work, and the use of vulnerability scenarios and indicators—such as external debt and reserve adequacy indicators—is now common in Article IV staff reports.25 Much of this effort relates to the assessment of countries’ vulnerability to changes in external circumstances and, in particular, to capital market conditions. A prime objective is to forestall crises by recommending policies that reduce vulnerabilities and strengthen the economies’ resilience to shocks.
External Vulnerability Assessment Framework for Emerging Market Economies
Vulnerability assessments are routinely conducted under the normal surveillance work of the IMF. However, special attention is placed on the external vulnerability of emerging market economies, given their high sensitivity to changes in global capital market conditions. In May 2001, a new framework was set up for bringing together staff’s assessments of vulnerabilities in these countries. It entails semi-annual inter-departmental exercises to identify underlying vulnerabilities and crisis risks drawing on quantitative vulnerability indicators, qualitative staff assessments, market information, and analyses of different scenarios for the global economic and financial market environment. Countries identified as vulnerable are kept under continuous surveillance. Reports on the results of these exercises are sent to Management and department heads. The Executive Board is kept informed through the informal country matters sessions, routine bilateral and multilateral surveillance reports, and ad hoc reports in times of particular turbulence.
Vulnerability assessments combine traditional flow indicators with indicators of balance sheet vulnerabilities, drawing on analyses of international liquidity or reserve adequacy, the fiscal position and the size and composition of debt and its sustainability, and financial soundness indicators.26
The Balance Sheet Approach
The balance sheet approach focuses on an analysis of the country’s aggregate and sectoral balance sheets to determine balance sheet exposure to shocks. The key sectoral balance sheets analyzed are those of the government, financial, household, and corporate sectors, with attention being placed on the composition of assets and liabilities and the inter-linkages among the sectoral balance sheets. The analysis focuses on four potential sources of balance sheet risks:27 (i) maturity mismatches (differences in the term structure of assets and liabilities), which result in insufficient liquid assets being available to cover liabilities falling due in the short term; (ii) currency mismatches (differences in the currency composition of assets and liabilities), which lead to capital losses or gains in the event of a change in the exchange rate; (iii) capital structure problems (excessive reliance on debt financing), which leave firms vulnerable to revenue and interest rate shocks; and (iv) solvency problems, where assets are insufficient to cover liabilities. Inter-sectoral linkages result in spillover of shocks from one sector to other sectors. Data availability is an important impediment to a wider usage of balance sheet analysis.
The focus here is on assessing the adequacy of a country’s level of foreign exchange reserves as a means of determining the country’s ability to withstand shocks. Measures of reserve adequacy currently used for this purpose include the ratio of reserves to short-term debt by remaining maturity, and to imports of goods and services. They are complemented by an analysis of, and careful judgments about, a country’s macroeconomic conditions and its structural and institutional characteristics, including its exchange rate regime. Measures have also been designed to broaden the analysis of reserve adequacy so as to capture the country’s ability to withstand a liquidity crisis stemming from certain kinds of imbalances in the balance sheets of residents. In addition, attention is being given to assessing the role of public debt management and private sector liability management in improving a country’s public and private sector balance sheets and reducing the risk of liquidity crises.
Debt Sustainability Analysis
Debt sustainability assessments (DSAs) form part of the IMF’s policy analysis in surveillance and program contexts. While there are central features of the debt sustainability analysis, a distinction is made between countries with significant capital market access and low-income countries. Debt sustainability analysis for low-income countries is modified to take account of special characteristics such as reliance on official financing, the nature of the shocks to which they are subject, and constraints on the resources necessary to repay their debts.
Debt sustainability analyses for countries with significant market access is undertaken mainly for emerging market countries, but also for industrialized countries. The analysis has three core elements: a baseline projection of medium- and long-term debt sustainability indicators, scenario analysis to determine the impact of varying the assumptions about the future trend of key variables, and inferences about the vulnerability of the country to a crisis. The analysis is done separately for public debt (external and domestic) and external debt (public and private), and the results are used to derive an understanding of overall debt sustainability.
The framework for debt sustainability analysis for low-income countries was developed in 2005.28 Its primary purpose is to form judgments on appropriate future borrowing policies taking into account country-specific circumstances in setting the debt-sustainability thresholds, without understanding them as rigid ceilings. It should also provide the basis for designing a country-specific borrowing strategy that is compatible with the country’s prospective repayment capacity. These DSAs should be prepared jointly with World Bank staff, and annual joint IMF-World Bank DSAs are required for all PRGF-eligible, IDA-only countries. The framework also constitutes an important addition to the IMF’s toolkit to assess the appropriate balance between adjustment, lending, grants, and debt restructuring or relief in low-income countries. The DSA should also enable other international financial institutions and donors to establish a coordinated approach to concessionality and guide the decisions of donors and creditors.
Within the group of low-income countries, debt sustainability analyses are required for countries that are actual or potential beneficiaries of the Heavily Indebted Poor Countries (HIPC) Initiative. The HIPC Initiative seeks to restore debt sustainability by providing debt relief. It is not a permanent mechanism, does not benefit all low-income countries, uses a single debt-sustainability threshold for all countries, and supports but does not guarantee debt sustainability in the future. The 2005 low-income country DSA provides transitional arrangements for the use of the new DSA framework for HIPC cases.
Financial Sector Assessment Program
The financial sector plays a key role in the generation and transmission of vulnerabilities. The existence of a wide and diversified set of sound, well-managed financial institutions and markets reduces the likelihood and magnitude of a financial crisis. The IMF launched the Financial Sector Assessment Program (FSAP) in May 1999, jointly with the World Bank, on a pilot basis, and the program became a regular activity of the IMF and the World Bank at end-2000.29 The objective of FSAP is to strengthen countries’ financial sectors through comprehensive, in-depth assessments to identify their strengths and vulnerabilities, and their linkages with the real economy, identify critical development priorities, and to provide country authorities with appropriate policy recommendations. These assessments feed into the Article IV surveillance process, the design of IMF-supported programs, and IMF technical assistance activities.30
Participation in the program is voluntary. A variety of criteria are used to establish priorities in selecting countries in the face of limited resources, including a country’s systemic importance, its external sector weakness or financial vulnerability, the nature of its exchange rate or monetary regime, and geographical balance among countries. Overall, the selection of countries is such as to help maximize the program’s contribution to the strengthening of national and international financial stability.
In addition to their own staff, the IMF and the World Bank draw on the knowledge of experts from a range of cooperating central banks, supervisory agencies, standard setting bodies and other international institutions in carrying out the assessments. In addition to augmenting the pool of expertise already available in the World Bank and the IMF, outside experts provide a valuable element of peer review to the analysis undertaken in the FSAP, particularly as regards the assessments of observance of financial sector standards and codes, which are an integral part of the program.
The FSAP provides important input into the Article IV consultation process. Ideally, FSAP mission work is completed about three months prior to the Article IV consultation mission to allow sufficient time for the draft FSAP findings to be available for discussion during the Article IV mission, in which FSAP team leaders usually participate. The FSAP assessments, combined with discussions of the FSAP findings during the subsequent Article IV consultation mission, serve as the basis for a Financial Stability Assessment (FSSA) report, which emphasizes stability issues of relevance to surveillance and which is provided to the Executive Board as part of the Article IV consultation documentation for a country. Summary assessments of financial sector standards prepared in the FSAP are included in the FSSA and are issued as Reports on the Observance of Standards and Codes (ROSCs). Publication of the FSSA reports has occurred in about 70 percent of cases, but this is voluntary and there is no presumption of publication.
The FSAP uses a number of complementary analytical tools to establish an overall assessment of the financial sector. These include financial soundness indicators and stress testing to identify risks and vulnerabilities; standards and codes to assess institutional and regulatory structures; assessment of the broader financial stability policy framework to determine the robustness of the financial sector infrastructure; and assessment of systemic liquidity arrangements, the governance and transparency framework, and financial safety nets and solvency regimes. Improved prioritization and streamlining have resulted in assessments that are better tailored to country circumstances.
Since the inception of FSAP, the program has been constantly improving. In particular, after the 2003 review of the Executive Board, measures were taken to ensure more focused assessments that are better tailored to countries’ circumstances. The 2005 review streamlined and rationalized the framework for FSAP updates, which were growing in importance since more countries had completed their initial assessments. FSAP updates may be targeted or comprehensive in cases where there have been extensive changes since the original FSAP. Typically, updates are undertaken about five years after the original FSAP, although the timing is flexible based on country circumstances. In 2006, the Board discussed an evaluation of FSAP by the Independent Evaluation office (IEO) and decided on a number of improvements, including better presentation of FSAP to facilitate its integration in the surveillance process, and strengthening of prioritization procedures.
Financial Soundness Indicators
These are indicators compiled to monitor the soundness of financial institutions and markets, and of their corporate and household counterparts. They are a subset of the broader class of macroprudential indicators that IMF staff use in macroprudential surveillance of the financial system. Financial soundness indicators comprise a core set and an encouraged set. The core set currently includes only banking sector indicators, and are given high priority in financial sector surveillance. The encouraged set includes additional banking sector indicators as well as indicators for the corporate and household sectors, non-bank financial institutions, and financial and real estate markets. A Compilation Guide on Financial Soundness Indicators has been published in collaboration with experts from member countries and from other international and regional organizations, to facilitate compilation of the indicators by national authorities.
Anti-Money Laundering and Combating the Financing of Terrorism
Since September 2001, the IMF has intensified its contribution to international efforts in anti-money laundering and combating the financing of terrorism (AML/CFT).31 These efforts seek to prevent the abuse of financial systems and to protect and enhance the integrity of the international financial system. Work on combating money laundering and terrorism financing was made a regular part of the IMF’s work in March 2004. It includes technical assistance to countries to help strengthen their ability to combat money laundering and terrorism financing. The IMF’s work in this area is undertaken in close cooperation with the World Bank, the Financial Action Task Force (FATF), and FATF-style regional bodies (FSRBs).
Offshore Financial Center Assessments
The IMF initiated the offshore financial center (OFC) assessment program in June 2000 on a pilot basis in response to concerns about potential risks posed to other financial systems by activities undertaken in offshore financial centers. The OFC program was permanently incorporated into its financial sector surveillance work in November 2003.32 Participation in OFC assessments and monitoring is voluntary.
The program has four broad components: regular jurisdiction-specific monitoring of OFCs’ activities and compliance with supervisory standards, improved transparency, technical assistance, and collaboration with standard-setters and supervisors to strengthen standards and information exchange. Assessments are closely coordinated with the FSAP to identify weaknesses in consolidated supervision, but the OFC program is currently independent of the FSAP, and members sometimes choose to have an FSAP rather than an OFC assessment. The program allows for a step-by-step process of assessment in three modules:
Module 1 assessments are a self-assessment of compliance with particular standards, undertaken by the jurisdiction with technical assistance as needed to begin the assessment process.
Module 2 assesses compliance of supervisory and regulatory systems with international standards in the banking sector and, if activity is significant, in the insurance and securities sectors, as well evaluating the regime for combating money laundering and terrorism financing. These are conducted every 4-5 years. In November 2003, the Executive Board agreed that the Module 2 main report would henceforth be reclassified as a staff report and circulated to the Board for information.
Module 3 assesses additional compliance with standards, cross-border and domestic risks and vulnerabilities and focuses on jurisdictions that are not covered by the FSAP. No jurisdiction has as yet opted for a Module 3 assessment.
Data Provision to the IMF for Surveillance Purposes
Comprehensive, timely, and accurate economic data are critical for prudent national policymaking, crisis prevention, and for effective surveillance. Article IV staff reports devote considerable attention to data issues and discuss the implications of data deficiencies for macroeconomic analysis and policy.
The Articles of Agreement require member countries to provide the IMF with the information it deems necessary to carry out its surveillance activities. In particular, Article VIII, Section 5 (a), specifically lists categories of data that members are required to provide, consistent with their capacity. In January 2004, the IMF expanded the categories of information deemed necessary for the conduct of its activities through the adoption of an additional list of data required to be provided by members. Beyond this minimum, the IMF relies on members’ cooperation to obtain data needed for surveillance, and in practice members voluntarily provide extensive data to the IMF that far exceed the requirements of Article VIII, Section 5.33
Article VIII, Section 5 requires members to report information to the IMF only to the extent that they have the capacity to do so. Therefore, there is no breach of obligation if a member is unable to provide the information required under this Article, or to provide more accurate information than it has provided. However, a member that is unable to provide final data is obligated to provide provisional data to the best of its ability until it is in a position to provide the IMF with the final data. Assessment of members’ capacity to report required information involves an element of judgment on the basis of best statistical practice and experience, and the IMF normally gives the member the benefit of the doubt.
Where a member reports required data inaccurately, or fails to report it, despite having the capacity to do so, the IMF makes every effort to secure a cooperative solution through intensified contacts. In those rare cases that are not amenable to cooperative approaches, the IMF acts in accordance with a framework of sanctions that takes account of remedies and corrective actions voluntarily taken by the member. In practice, the Managing Director first issues a report to the Executive Board describing the alleged breach under Article VIII, Section 5, after notifying the authorities of his intention to issue such a report and giving them sufficient time to demonstrate that they are unable to provide the information or to provide more accurate information. Within 90 days of issuance of this report, the Executive Board takes a decision on whether the member has breached its obligation and may call upon the member to take remedial actions. If the member fails to implement the specified actions within the deadline, the IMF may decide to issue a declaration of censure against the member. Following the issuance of the declaration of censure, and in case of a continued failure by the member to adopt remedial actions, the IMF may decide to impose the sanctions of Article XXVI.
Surveillance in Program Countries
The IMF has emphasized the special role that surveillance has to play in program countries by providing a fresh perspective on economic conditions and policies.34 Surveillance and IMF balance of payments support promote or restore macroeconomic stability, external viability, and sustained economic growth. Nevertheless, in countries with IMF-supported economic programs, “stepping back” from the program environment provides a broader perspective on the economic challenges facing the country and the adequacy of current policies to meet those challenges. This is particularly relevant for countries that are prolonged users of IMF resources.
Consequently, surveillance consultation cycles have been made more flexible in program countries, in recognition that surveillance is more effective at some points in the program cycle—for example, before a program is negotiated, when a program has moved off-track, or when a major change in program strategy is envisaged between programs—than at others. To further separate program and surveillance analysis, separate mission teams have been used in some cases for surveillance and program discussions.
The implementation of the IMF’s surveillance and of the 1977 decision on surveillance is reviewed on a triennial basis by the Executive Board.
The term “buff” derives from the distribution of these statements on buff or similarly colored paper. Statements by other Executive Directors are called “gray” statements for a similar reason, although these statements are now distributed electronically.