2014 Triennial Surveillance Review - Staff Background Studies

Abstract

2014 Triennial Surveillance Review - Staff Background Studies

III. Scope of Surveillance in Low-Income Countries1

Executive Summary

The purpose of this review is to: (i) examine the evolution of Fund surveillance of low-income countries (LICs) in recent years; (ii) assess the extent to which the cross-cutting recommendations of the 2011 Triennial Surveillance Review (TSR) and the ensuing Guidance Note have been implemented in staff work on LICs; and (iii) discuss whether this general guidance needs to be modified or augmented for LICs.

Policy issues that are of particular importance in surveillance of LICs include growth promotion, poverty reduction and economic inclusion, effective management of natural resource wealth, financial deepening, and economic diversification and structural transformation. In most countries, direct links to international capital markets are relatively weak, limiting spillovers from international capital market developments—but there are now a significant minority of frontier market LICs that have begun to actively access global capital markets and attract portfolio inflows. The conduct of surveillance is affected by LICs’ institutional capacity limitations, deficiencies in the quality and availability of data, and stronger Fund engagement through programs and technical assistance.

Based on a review of 25 Article IV reports for LICs, the paper finds that adoption of the recommendations of the 2011 TSR has helped enhance the effectiveness of surveillance in recent years. The quality of work could, however, be enhanced in a number of areas:

  • The analysis of spillovers and risks would be improved by discussing channels and policy implications more systematically. Financial stability analysis would benefit from greater discussion of links between the real and financial sectors. External stability assessments can be enriched by broadening the analysis beyond the current, heavy emphasis on exchange rate assessments.

  • Traction could be further enhanced by tapping more the Fund’s knowledge of country experiences and using the experience of other countries to shed light on the policy challenges facing national authorities in LICs.

Surveillance in LICs has also progressed in those areas of specific importance to LICs, flagged above, in line with the 2012 Surveillance Guidance Note. Areas where further progress could be made include:

  • While surveillance reports rightly devote substantial attention to structural determinants of growth, the analysis could be strengthened within the confines of staff expertise and resources.

  • The attention given to poverty reduction and inclusion in surveillance reports has increased in recent years, but there is scope for doing more in many cases, including by building on recent Fund work on addressing inequality while protecting growth and by drawing on the expertise and diagnostics of other development institutions.

  • The Fund has significant expertise in the areas of taxation of natural resource activities and macroeconomic management of resource revenues. Country teams could, in many cases, draw more on this body of work.

  • There is room for strengthening the analysis and advice on financial deepening, including through closer engagement with other agencies, including the World Bank. Where deepening occurs, surveillance will need to focus on identifying how potential risks to financial stability from rapid credit growth and weak institutions can be contained.

Finally, the Fund deploys significant resources to capacity-building efforts in LICs, recognizing that weaknesses in institutional capacity, alongside poorly-designed policies, can impose large costs on national economies. The quality of LIC surveillance could, in many cases, be enhanced by drawing more on the sizeable body of knowledge generated by the extensive technical assistance; reports could also be strengthened by more discussion of as to whether capacity-building efforts are achieving the desired results and whether key recommendations of technical assistance have been endorsed and implemented.

A. Introduction

1. The goal of Fund surveillance is to promote the macroeconomic stability of member countries as well as the effective operations of the international monetary system, including through maintaining global stability. Policies that affect a country’s economic stability are not limited to exchange rate, monetary, and fiscal policies, and can include policy areas such as administrative, institutional, and sectoral reforms, financial sector policies, and natural resources management if these areas affect stability. The Fund can also examine whether policies are not only keeping the economy broadly at capacity but also supporting a higher rate of potential growth where such higher growth significantly influences prospects for stability.2

2. Drawing on the lessons from the global financial crisis, the 2011 Triennial Surveillance Review (TSR) established five priority areas with a view to strengthening surveillance across all Fund member countries. In particular, it called for greater focus on: (i) interconnections and policy spillovers; (ii) in-depth risk assessments; (iii) financial stability; (iv) renewed emphasis on external stability assessments; and (v) enhanced efforts to gain traction including through greater candor and relevance (e.g., adequate coverage of macro-social issues). A revised Guidance Note for Surveillance under Article IV Consultations was issued in 2012.

3. As specified in the Guidance Note, the set of issues of potential relevance for Article IV consultations in low-income countries (LICs) is generally broader than is the case for other countries. Surveillance in low-income countries should, as in other countries, focus on whether policies are contributing to domestic and balance of payments stability, but the range of issues to be covered will often include such topics as management of natural resources, the promotion of financial deepening, and macro-critical social issues (such as poverty reduction and employment). Issues that may warrant coverage on occasion include sectoral policies to support growth, export diversification, and governance issues that have a significant impact on macroeconomic stability.3

4. This paper reviews how the 2011 TSR priorities and ensuing guidance have been applied in surveillance of low-income countries (LICs) and seeks to identify areas where greater emphasis is called for and/or current practices could be improved.4 Some issues relevant to LIC surveillance are examined in other background papers for the 2014 TSR, including the study of fiscal policy advice and the review of bilateral and multilateral surveillance products.

5. The paper proceeds in two main steps. Section II provides a brief discussion of distinctive features of surveillance in LICs. Drawing on a sample of recent Article IV consultation reports, Section III reviews the implementation of the 2011 TSR priorities and the associated guidance to staff on LIC surveillance in the ensuing period. Section IV presents the most important findings and concludes.

B. Surveillance in LICs: Distinctive Features

6. The economic issues at center stage in surveillance of LICs differ in some important respects from those covered in more advanced economies, reflecting distinctive structural features of LIC economies (Figure 1):5

  • With some important exceptions, the combination of concentrated export structures and relatively weak links to international capital markets implies that inward spillovers typically feed into the domestic economy via the traded goods sector rather than through financial channels.

  • The exception is the small but increasing number of “frontier economies” in the LIC universe that have been attracting non-FDI private capital inflows in recent years and thus are now also exposed to financial sector spillovers.6

  • The perceived inability of LICs to achieve adequate structural transformation and export diversification has put these issues at the center of policy-makers’ concerns in many countries; and, hence, is receiving significant attention in the surveillance dialog with the Fund.

  • The shallowness of domestic financial markets in many LICs acts as a key constraint on fiscal policy activism and, more generally, on economic development, while also impairing monetary transmission mechanisms.7 Effective surveillance needs to internalize these constraints while contributing to the policy discussion on financial deepening, where feasible.8

  • With the preponderance of the labor force employed in subsistence agriculture or other informal-sector activities, policies affecting the formal labor market typically feature less significantly in surveillance and human capital development often receives greater attention.

  • Poverty reduction and economic inclusion are typically key priorities for LIC governments, with poverty-oriented and developmental spending usually supported by sizeable inflows of aid from development partners. Issues relating to poverty reduction inevitably feature in surveillance, although Fund expertise in this area is relatively narrowly focused, with core expertise housed in the World Bank and other development banks and agencies.

Figure 1.
Figure 1.

Contrasting LIC and Non-LIC Fund Member Countries (Median, 2004–13)

Citation: Policy Papers 2014, 059; 10.5089/9781498343077.007.A003

Sources: WEO, WGI, IFS,WDI, updated and extended version of the Lane and Milesi-Ferretti (2007) dataset, and staff calculations.

7. The conduct of surveillance in LICs is also influenced by a number of special factors:

  • The main institutions of economic governance and policy implementation in LICs often suffer from serious capacity limitations, limiting the range of policies that can be implemented while also impeding the pace of policy reforms. Capacity building is a priority for both LIC governments and their development partners (including the Fund), but is usually a long-term process rather than a “quick win.”

  • The quality and timeliness of economic data is typically poor, undermining the ability of both policy-makers and Fund staff to assess current developments and draw lessons from statistical analysis of historical data. Analysis of policy issues is thus subject to a heightened level of uncertainty, while statistical analysis of macroeconomic time series is frequently unreliable.

  • The Fund is heavily engaged in many LICs via financial programs of various forms and/or through strong support for capacity-building in areas where the Fund has specialist expertise. In these cases, staff typically have an ongoing close policy dialog with national authorities (including via resident representatives), along with access to a substantial body of knowledge generated by technical assistance experts.

  • Development institutions, notably the World Bank, that have expertise in areas relevant, but not central to, the Fund’s mandate typically also have substantial involvement in LICs. There is substantial scope for effective information-sharing and division of labor across policy areas with these institutions, expanding the available knowledge base for Fund surveillance while facilitating selectivity in coverage of policy issues by the Fund. While there is substantial collaboration in LIC work with development institutions, in particular the World Bank, fully exploiting these opportunities is often a significant challenge.9

8. LICs as a group receive limited attention in the Fund’s flagship products, reflecting the fact that LICs account for a very small share of global output and of other macroeconomic aggregates.10 That said, the World Economic Outlook (WEO), including its detailed database, provides a key input for analyzing the economic outlook for individual LICs by providing quantitative projections for major global and country-specific aggregates, including the evolution of global trade, inflation, and key commodity prices. Enhanced efforts to incorporate LICs (as a group) into global modeling exercises and to provide more disaggregated commodity price forecasts could significantly enhance the value of WEO outputs for LIC analysis.

C. Implementation of Current Guidance in LIC Surveillance

Background

9. In the period since the completion of the 2011 TSR, LICs have generally recorded strong economic growth, albeit with a significant number of countries falling behind in the face of conflict/fragility, debt burdens, natural disasters, or poor economic policies. The most significant structural change in the LIC universe recorded during this period has been the emergence of frontier market LICs – countries that have begun to access international capital markets in one or more forms, helped by the conjunction of strong growth rates, low debt levels (post HIPC-MDRI), and exceptionally low interest rates in advanced economies. In some cases, countries that retain closely controlled capital accounts have opted to access international capital markets via sovereign bond issues; in other cases, countries that have more open capital accounts have been attracting portfolio inflows into domestic financial markets while also tapping the sovereign bond markets. Macroeconomic policy challenges have changed markedly for this second grouping of countries. While opening up to global capital markets yields many benefits, among them opportunities to boost growth and foster risk sharing, it also brings with it the potential volatility of capital flows, particularly portfolio flows, an important new risk factor that requires careful management11

10. A review of a sample of 25 Article IV reports for LICs finds that the introduction of the 2011 TSR priorities has helped sharpen surveillance, with due consideration being given to the features described above, in particular the differentiated integration of LICs in global financial markets.12 Part of the progress also reflects the expansion of the Fund’s analytical toolkit for LIC issues.13 There is room, however, for strengthening the implementation of the 2011 TSR priorities in some areas: while reports appear to focus on the right sets of risks (narrower for most LICs and wider for frontier countries), the analyses of risks and spillovers, financial stability, and external stability could be deepened further.

Strengthening Analysis of Interconnections and of Risks

11. Discussions of inward spillovers and risks rightly focus on the risks most relevant for LICs, and the depth of the discussion has improved, but there is room for deepening the analysis further in a few areas:

  • Almost all Article IV reports in the sample appropriately discuss risks related to commodity prices, and most discuss risks related to global growth. Reports also take account of aid and remittance flows where relevant. More specifically, three-quarters of the reports for highly aid-dependent countries cover risks from disruption in aid flows. Also, almost all reports for countries where inward remittances are significant cover risks from a possible decline in remittances. In frontier economies, discussions of spillovers and risks also consider risks transmitted through global capital markets and their impact on the domestic financial sector.

  • The depth of the discussion of spillovers and risks has also improved. Risk analysis is now supported by near-universal inclusion of risk assessment matrices; about three out of four reports discuss both the channels through which risk realization and spillovers would affect the economy (albeit only rarely in a quantitative fashion); and about the same share discusses policy implications. Further progress could be made by discussing transmission channels and implications for policy settings more systematically.

  • Progress could also be made by using quantitative methods more frequently, in cases where data availability permits. This could take different forms, such as the use of macroeconomic framework-based scenario analysis or the incorporation of methods used in the Vulnerability Exercise for LICs (VE-LIC).

Improving Financial Stability Analysis

12. Financial stability analysis focuses on the relevant threats, but there is room for further improvement. In countries not integrated into global capital markets, discussions related to the financial sector appropriately focus on domestic threats. In frontier economies, analysis of financial sector stability often extends beyond domestic risks to take into account risks from financial openness: three out of four of reports for these countries provide some discussion of risks from the size and volatility of capital flows. Regarding the depth of the discussion, in both frontier and other countries, a large majority of reports provide some bottom line on financial sector vulnerabilities, but there is fairly limited discussion of links between the financial sector and the real sector. Most reports also provide limited follow-up on Financial Sector Assessment Programs (FSAPs). Finally, discussions on the appropriate management of capital flows frequently remain vague, perhaps reflecting the only recently formed Institutional View on this sensitive issue, perhaps also reflecting insufficient knowledge of the existing institutional controls.14

Enhancing External Stability Analysis

13. Assessments of external stability continue to show some weaknesses. Almost all reports provide a real exchange rate assessment using the methodologies of the Consultative Group on Exchange Rate Issues (CGER), and more than half of the reports assess the level of reserves, in line with guidance to broaden external stability analysis beyond the assessment of real exchange rates. However, while use of the CGER approaches is mandated, authorities have voiced doubts regarding this methodology and, on the whole, these approaches have gained only limited traction with counterparts. Difficulties in providing meaningful CGER-type analysis reflect, in part, the problems of data availability cited previously. Further, external stability assessments and the associated policy recommendations are often not very well integrated with other parts of the analysis and policy advice (as is the case also in surveillance of countries at higher levels of income). For example, a substantial share of the reports reviewed contained only limited discussion of the appropriate mix of policies to address both domestic and external imbalances. Less than one-third of the external stability assessments for resource-rich LICs contained adjustments to reflect the implications of resource exhaustibility (a substantially lower share than in the case of resource-rich countries with higher income levels).

14. Accordingly, external stability assessments could be made more meaningful through a series of actions. External stability analysis could benefit from continued efforts to provide a broader perspective, for example by offering more comprehensive discussions of current-account-balance developments and reserve adequacy. Integrating elements of balance sheet analysis such as consideration of risks of private capital flow reversals, currency and maturity mismatches, and foreign financing requirements would also help. Further, where sufficient data are available, assessments could adopt stronger methodologies for the analysis of real exchange rates, for example, approaches akin to the External Balance Approach.15 Real exchange rate analysis could also adjust more systematically for the presence of exhaustible resources. Finally, assessments could be more useful if they were better integrated with other elements of the analysis, rather than serving as something of a stand-alone exercise.

Strengthening Traction of Fund Policy Advice

15. The Fund is relatively successful at gaining traction with its policy advice in LICs, a point that was flagged already in the analysis undertaken for the 2011 TSR and that has been confirmed this time again. The stronger traction in LICs reflects several factors, including the leverage derived from the provision of Fund financing in many countries, the catalytic role of the Fund in influencing donor financial support, the capacity limitations of many domestic policy-making agencies, and the credibility-enhancing impact of well-executed technical assistance.

16. The Fund is arguably improving its ability to gain traction for its policy advice in LICs by paying greater attention to policy issues of specific concern to national authorities, using cross-country experience to inform domestic policy debates, and enhancing its outreach efforts to civil society. For example, the Fund’s extensive work on the appropriate tax regime for natural resource sectors and the macroeconomics of managing resource revenue volatility has addressed a set of issues that are central to an increasing number of LICs, drawing on experiences across many countries.16 Similarly, the substantial body of cross-country work on the energy subsidy reforms addressed in an accessible manner a sensitive but strategically important reform issue in a large number of LICs.

17. Enhancing traction in the future will require giving greater attention to tapping the Fund’s knowledge of country experiences and using the experience of other countries to shed light on the policy challenges facing national authorities in LICs. This is a message that is repeatedly conveyed by country authorities.

Implementation of LIC-Specific Surveillance Guidance

18. The post-2011 TSR guidance on Fund surveillance of LICs underscored that the range of issues to be covered in LICs would typically be broader than that in more advanced economies, reflecting the specific circumstances and characteristics of LICs. Issues likely to be covered included measures to accelerate the pace of economic growth, effective management of natural resources, the promotion of financial deepening, and macro-critical social issues such as poverty reduction and inclusion. Issues seen as being possible candidates for attention included sectoral policies to support growth, the promotion of export diversification, and macro-critical governance issues. At the same time, the choice of issues to be covered in individual consultations was to be guided by the principles of focus and selectivity, with staff making a judgment, reflecting both country circumstances and Fund-wide surveillance priorities, as to the particular issues that merited in-depth treatment. We examine here how a number of these key issues are being handled in Fund surveillance.

Promotion of Economic Growth

19. While the surveillance reports reviewed for this paper rightly devote substantial attention to structural determinants of growth, the analysis could in many cases be strengthened within the confines of staff expertise and resources. A large majority of reports provides an extensive discussion of challenges to long-term growth, but the strength of the analysis is uneven and often focused exclusively on the need to improve competitiveness and the business environment; while some reports identify country-specific bottlenecks, many present only a broad checklist of potentially relevant factors (which is of limited value to policy-makers). Deepening staff analysis is challenging, given that the Fund is not itself a center of expertise in this area and that deriving a sound analytical understanding of the factors driving growth at any specific point in time is difficult even for specialists.17 One option could be for staff to conduct “growth diagnostics;”18drawing on the specialist expertise of other development agencies, including the World Bank, to enhance staff analysis and diagnostics.19

Poverty Reduction and Inclusion

20. The attention given to poverty reduction and inclusion in surveillance reports has increased in recent years, but there is scope for doing more in many cases. Only about half of the reports reviewed provide a substantive discussion of poverty incidence and policies that might reduce it, with about one third of the reports making an analytical contribution.20 With inclusion playing a key role in helping to overcome harmful feedback loops between inequality, poverty, and instability,21 staff work on these issues should be expanded, including by building on recent Fund work on addressing inequality while protecting growth and by drawing on the expertise and diagnostics of other development institutions.22

Effective Management of Natural Resources

21. The Fund has significant expertise in the areas of taxation of natural resource activities and macroeconomic management of resource revenues—issues that are of strategic importance to a large and increasing number of LICs. The Fund is providing substantial technical assistance to LICs on resource taxation issues, producing a sizeable body of policy advice to be drawn on in the surveillance process. Major staff papers on both natural resource taxation issues and macroeconomic management of natural resource revenues were produced in 2012, the latter laying out policy frameworks for resource-rich countries to help determine appropriate levels of savings from and investment of resource revenues, taking into account macroeconomic and institutional capacity constraints while avoiding boom-bust cycles.23 New approaches and modeling techniques for resource-rich developing countries have been developed to evaluate such issues as the optimal pace of scaling-up investment. However, the review of surveillance reports undertaken for this paper suggests that many country teams could draw more effectively on this body of work to enhance the quality of advice conveyed in the surveillance process.

Promoting Financial Deepening

22. Financial systems in many LICs are characterized by low depth, breadth, and reach of financial services, with significant concentration of credit among a small pool of “blue-chip” borrowers. While many surveillance reports appropriately emphasize the importance of financial sector development in LICs, there is room to strengthen the analysis and advice that is being provided. Work on financial sector deepening could be enhanced by building on the recommendations in Enhancing Financial Sector Surveillance in Low-Income CountrieFinancial Deepening and Macro-Stability (IMF 2012), including by benchmarking domestic financial sectors against peers. Reports could also make clearer the extent to which underdeveloped financial systems hamper the effective conduct of macroeconomic stabilization and monetary policy. Some progress towards this goal has been made in the context of selected pilot cases on financial deepening over the period 2012–13 (Box 1). Rolling out this approach to a larger number of LICs would provide significant policy insights, but the experience with the pilot cases has shown that the exercise is resource-intensive, with scaling up being difficult in the context of resource constraints. Closer engagement with, and reliance on, the expertise of other agencies, including the World Bank, could help to enhance staff diagnostics and recommendations without requiring a large injection of additional resources. Where deepening occurs, surveillance will need to focus on identifying how potential risks to financial stability from rapid credit growth and weak institutions can be contained.

Structural Transformation and Diversification

23. Concentration of economic activities, particularly export concentration, leaves LICs vulnerable to sector-specific shocks and is often seen as a significant impediment to growth over the medium-term, with countries “trapped” in products that have limited scope for productivity improvements. In part responding to demands from country authorities, Fund staff have been giving increased attention to issues relating to effective promotion of diversification, including undertaking extensive cross-country empirical research.24 Application of this analysis to country surveillance is a work in progress at this juncture, albeit with many country teams strongly interested in undertaking work in this area. It should be noted that, where opportunities for transformation and diversification are limited, as in many small states, or are likely to take many years to fully exploit, the policy dialog in surveillance will need to remain focused on building adequate buffers to handle the elevated volatility associated with low levels of diversification.

Strengthening the Linkages between Surveillance and Capacity-Building

24. The Fund deploys significant resources to support capacity-building efforts in LICs, recognizing that weaknesses in institutional capacity, alongside poorly-designed policies, can impose large costs on national economies. There is substantial scope for Fund surveillance to exploit the body of knowledge and expertise acquired through capacity-building efforts.25 While most surveillance reports reviewed for this paper discuss Fund capacity building efforts to some degree, the review suggests that there is significant room to draw more on this body of knowledge to inform the surveillance process. Reports often leave unclear the extent to which capacity-building efforts are achieving the desired results or the degree to which key recommendations of technical assistance have been endorsed and implemented. LIC surveillance reports would benefit from providing a more comprehensive discussion of capacity limitations and capacity development activities, including the strategies pursued and the progress achieved in strengthening capacity. For this, area departments could seek the support of TA-providing departments.

25. Synergies between surveillance and capacity development could be fostered through enhanced collaboration between staff engaged in surveillance and staff engaged in capacity development. Joint participation in missions would be an important step in ensuring both enhanced knowledge-sharing and laying the basis for sustained collaboration over time.

D. Conclusions

26. Surveillance for LICs has strengthened in recent years, thanks in part to the adoption of the 2011 TSR priorities, the ensuing guidance note, and efforts to broaden the surveillance toolkit. Nevertheless, some further progress is possible in the implementation of the 2011 TSR recommendations and other LIC-specific surveillance issues. Greater use of cross-country analysis and recent analytical tools relevant for surveillance in LICs will also contribute to more effective surveillance.

27. The following are key findings for enhancing surveillance in LICs:

  • Priorities of the 2011 TSR:

    • In analyzing spillovers and risks, further progress could be made by discussing channels and policy implications more systematically. Financial stability analysis would benefit from greater discussion of links between the real and financial sectors. External stability assessments can be enriched by broadening the analysis beyond its current heavy emphasis on exchange rate assessments to encompass risks to stability from both current and capital accounts, and by facilitating closer integration with other elements of staff analysis.

    • Surveillance for frontier countries needs to pay appropriate attention to the risks stemming from adverse spillovers from global capital markets. These countries would also benefit from enhanced advice on capital account liberalization and the management of capital flows.

    • Traction could be further enhanced by giving greater attention to tapping the Fund’s knowledge of country experiences and using the experience of other countries to shed light on the policy challenges facing national authorities in LICs.

  • Implementation of LIC-specific guidance:

    • While surveillance reports rightly devote substantial attention to structural determinants of growth, the analysis could, in many cases, be strengthened within the confines of staff expertise and resources.

    • The attention given to poverty reduction and inclusion in surveillance reports has increased in recent years, but there is scope for doing more in many cases, including by building on recent Fund work on addressing inequality while protecting growth and by drawing on the expertise and diagnostics of other development institutions.

    • The Fund has significant expertise in the areas of taxation of natural resource activities and macroeconomic management of resource revenues. Country teams could draw more on this body of work.

    • There is room for strengthening the analysis and advice on financial deepening, including through closer engagement with other agencies, including the World Bank. Where deepening occurs, surveillance will need to focus on identifying how potential risks to financial stability from rapid credit growth and weak institutions can be contained.

  • Strengthening linkages between surveillance and capacity building:

    • In many cases, LIC surveillance could do a better job of exploiting the rich body of knowledge available from the extensive capacity building efforts of the Fund and other agencies. Reports often leave unclear the extent to which capacity-building efforts are achieving the desired results or the degree to which key recommendations of technical assistance have been endorsed and implemented.

Enhancing Financial Sector Surveillance in Low-Income Countries, Experience with the Pilot Cases

In May 2012, the Executive Board discussed a staff paper on Enhancing Financial Sector Surveillance in LICs (EFSL) (FO/DIS/12/66, 04/16/2012). This initiative followed from the recommendations of the 2011 Triennial Surveillance Review, which called for more work on financial stability in LICs, including deeper coverage in Article IV reports and a regular strategic work plan for promoting financial stability.

This paper examined the nexus between financial deepening and macro-financial stability and the implication for Fund surveillance. It suggested that shallow financial markets could significantly impair the effectiveness of macro policy tools. For example, the absence of deep and liquid debt markets could weaken the capacity to implement countercyclical fiscal policy, limit the monetary transmission mechanism, and diminish opportunities for households to smooth consumption. The paper proposed a series of country pilot studies be undertaken to discern how sustainable financial deepening could enhance macroeconomic policy effectiveness and implementation in specific country cases.

The first set of seven pilots—which had different formats and focuses—have been completed. Six countries (Bhutan, Benin, Ghana, Haiti, Senegal, and Sudan) and one currency zone (WAEMU) were covered in the exercise. The focus has been on access to finance, financial stability, and fiscal dominance, depending on country circumstances. A common thread from the pilots was the ability to identify the particular set/subset of constraints on financial system development, with a perspective to enhance the effectiveness of macroeconomic policy implementation and macro-stability, including through Fund TA

These pilots have shown considerable promise. The authorities involved have welcomed the enhanced focus on their financial challenges, which has been useful in extending analysis and informing the policy dialogue. This includes improving the quality of data and addressing data gaps, to permit for stress-tests for instance, or broadening the scope of supervision to cover shadow banks (such as cooperatives), insurance companies, and micro-finance institutions that are mushrooming in some of these countries. Institutional reforms were also highlighted, including the lack of formal frameworks for monitoring and addressing systemic risks.

This pilot exercise has offered important lessons for the Fund’s work in LICs:

  • They have demonstrated the need and a shared desire to better integrate financial sector issues in the regular bilateral surveillance context, a key strategic goal of the Fund.

  • They have provided “on-the-ground” examples of how underdeveloped financial systems affect the ability of country authorities to implement fiscal/monetary policy.

  • The pilots have enhanced the linkages and promoted synergies between the Fund’s TA work on financial issues and its surveillance and program work.

  • They have provided a vehicle for leveraging the Fund’s financial sector knowledge and helped fill the gap that is sometimes left as a result of the low frequency and relatively small number of FSAP assessments in non-systemic countries.

Annex I. Sample of Article IV Reports

The sample of 25 Article IV reports for LICs and regional groups used in this study was chosen to be broadly representative across the regional and program status dimensions of LICs (see table below). With a cut-off date of end-2013, it includes the latest available reports for Afghanistan, Bangladesh, Benin, Bolivia, Cambodia, Chad, Democratic Republic of Congo, Cote d’Ivoire, ECCU, Ethiopia, Ghana, Grenada, Haiti, Kenya, Mozambique, Nigeria, Papua New Guinea, Samoa, Sudan, Tajikistan, Tanzania, Timor Leste, Vietnam, WAEMU, and Zambia.

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The term “program” here denotes all forms of engagement that go beyond surveillance, including for example staff-monitored programs.

Annex II. New Analytical Tools Relevant for Surveillance in LICs

This annex lists and briefly describes papers prepared by Fund staff since 2011 that present new analytical approaches and tools relevant for surveillance in LICs.

Vulnerability and Risk Assessments

Financial Sector Issues

External Stability and Debt

Growth

Inclusion and Income Distribution

  • Jobs and Growth: Analytical and Operational Considerations for the Fund, IMF 2013.

    • - Provides recommendations on how the Fund could further enhance its work on jobs and growth.

  • Guidance Note on Jobs and Growth Issues in Surveillance and Program Work, IMF 2013.

    • - Provides guidance in improving analysis and policy advice on macro-critical domestic policies, growth and employment challenges, tax and expenditure policies, and labor market policies.

  • Fiscal Policy and Employment in Advanced and Emerging Economies, IMF 2012.

    • - Identifies structural labor-market weaknesses in advanced and emerging economies; discusses the impact of tax and expenditure policies on employment; and provides a menu of tax and expenditure measures to boost employment.

  • Fiscal Policy and Income Inequality, IMF 2014

    • - Describes experience with different fiscal instruments for redistribution; lays out options for the reform of expenditure and tax policies to help achieve distributive objectives in an efficient manner; and presents evidence on how fiscal policy measures can be designed to mitigate the impact of fiscal consolidation on inequality.

  • A. Berg and J. Ostry, 2011, Inequality and Unsustainable Growth: Two Sides of the Same Coin? IMF Staff Discussion Note 11/08.

    • - Discusses the complex relationship between income inequality and economic growth. Finds that longer growth spells are robustly associated with more equality in the income distribution.

  • A. Berg, J. Ostry, and C. Tsangarides, 2014, Redistribution, Inequality, and Growth, IMF Staff Discussion Note 14/02.

    • - Finds that more unequal societies tend to redistribute more; that lower net inequality is correlated with faster and more durable growth, for a given level of redistribution; and that redistribution appears generally benign in terms of its impact on growth. Concludes that the combined direct and indirect effects of redistribution—including the growth effects of the resulting lower inequality—are on average pro-growth.

Resource-Rich Countries

Capacity Development

Small States

Fragile Countries

1

Prepared by a staff team comprising Xavier Maret and Hans Weisfeld (leads), Julia Bersch, Lars Engstrom, Gilda Fernandez, Kerstin Gerling, Vera Kehayova, Jung Kim, and Perry Perone (all SPR), Carla Macario and Aleksandra Zdzienicka (both AFR), and Neil Saker (APD). Patrick Imam and Paul Mathieu (both MCM) contributed Box 1 on financial deepening. Chris Lane and Sean Nolan provided general guidance.

2

See the discussion of the Fund’s mandate in the Guidance Note for Surveillance under Article IV Consultations, IMF 2012 and in Jobs and Growth: Analytical and Operational Considerations for the Fund, IMF 2013 and the Guidance Note on Jobs and Growth Issues in Surveillance and Program Work, IMF 2013.

3

See paragraph 8 of the 2012 Guidance Note. Whether a specific issue warrants coverage in an individual country is dependent on country circumstances.

4

For the purposes of this study, the LIC grouping is defined to be the 73 PRGT-eligible countries plus Zimbabwe, which has been temporarily ruled ineligible due to arrears.

5

It is important to underscore the heterogeneity of LICs, which vary markedly in terms of population size, human capital endowments, access to international trade routes, political stress, etc. Specific guidance notes have been produced on Fund engagement (including surveillance) with countries in fragile situations and with small states.

6

In this paper, the countries included in the “frontier LIC” grouping are: Bangladesh, Bolivia, Cote d’Ivoire, Ghana, Honduras, Mongolia, Nigeria, Rwanda, Senegal, Vietnam, and Zambia. These countries have recently tapped international financial markets.

7

For an example of how policy transmission can be different in LICs see for example A. Berg, L Charry, R. Portillo, and J. Vlcek, 2014, “Seven Questions on the Monetary Transmission Mechanism in Low-Income Countries,“ IMF Research Bulletin, Vol. 15, No. 2 (June), and the references therein.

8

Design of effective policies to promote financial deepening typically requires significant technical expertise; policy dialogue on this issue as a component of surveillance would be dependent on the pre-existing availability of the relevant technical analysis and/or the participation in surveillance missions of technical experts.

9

There is a long history of, and a well established framework for, collaboration with the World Bank. As laid out in the 1989 IMF-World Bank Concordat and the 2007 Joint Management Action Plan on Bank-Fund Collaboration, this collaboration follows a lead-agency model. The model provides that the Fund has the primary responsibility to provide short-term macroeconomic analysis and related policy advice, while the Bank has the primary responsibility to advise on development strategies, sectoral policies, public expenditure priorities, and poverty reduction. In addition, there are areas of shared responsibility, for example, in public financial management.

10

The Fiscal Monitor, as part of its coverage, is now giving specific attention to developments in LICs.

11

An analysis of risks and benefits of international financial integration at different levels of development is provided in M. Ayhan Kose, Eswar S. Prasad, and Ashley D. Taylor, 2009, Thresholds in the Process of International Financial Integration, NBER Working Paper 14916.

12

Annex I describes the sample. The findings from this sample are largely consistent with the ones made for LICs through surveys of surveillance stakeholders and in a broader review of surveillance through a sample of 50 Article IV reports (“2014 Triennial Surveillance Review – Review of IMF Surveillance Products”). A key difference between the two reviews lies in the focus of the present study on how implementation of the TSR priorities corresponds to LIC specificities.

13

A detailed review of new analytical toolkits and research is presented in Annex II.

14

The Liberalization and Management of Capital Flows: An Institutional View, IMF 2012.

15

This will require efforts from functional departments to provide such tools. Efforts are under way to extend the External Balance Assessment (EBA) methodology to low-income countries.

16

Dissemination of Fund work and country experiences were the main themes of the 2013 Fund’s African Department conference in Kinshasa on the management of natural resources in Sub-Saharan Africa.

17

Hausmann, R., Pritchett, L., and Rodrik, D., 2004, Growth Accelerations, NBER Working Paper 10566.

18

Guidance Note on Jobs and Growth Issues in Surveillance and Program Work, IMF 2013, provides a how-to guide for growth diagnostics.

19

Collaboration with the World Bank is governed by the Bank-Fund Concordat and the Joint Management Action Plan on Bank-Fund Collaboration (JMAP). Under the JMAP, Bank and Fund country teams are to meet at least once a year to discuss how they can best collaborate to help a country address its macroeconomic and macro-critical structural challenges. The outcome of the meeting is to be presented in a staff report appendix on Bank-Fund collaboration.

20

Coverage of poverty reduction was found to be less extensive in Article IV reports for program countries than in those for other countries. This may reflect in part other reporting on poverty reduction in the program documents.

21

There is evidence that a high levels of poverty and inequality tend to lead to social conflict and to economic crises, see for example: A. Berg and J. Ostry, 2011, Inequality and Unsustainable Growth: Two Sides of the Same Coin? IMF Staff Discussion Note 11/08, and Campante, F. and Chor, D., 2012, “Why Was the Arab World Poised for Revolution? Schooling, Economic Opportunities, and the Arab Spring,” Journal of Economic Perspectives, Vol. 26(2), pages 167–88.

22

See Fiscal Policy and Employment in Advanced and Emerging Economies, IMF 2011 and Fiscal Policy and Income Inequality, IMF 2014. Note in this context that recent empirical work has found no evidence to support the notion that income redistribution depresses growth, except perhaps in cases of very high degrees of redistribution, see A. Berg, J. Ostry, and C. Tsangarides, 2014, Redistribution, Inequality, and Growth, IMF Staff Discussion Note 14/02.

23

See Macroeconomic Policy Frameworks for Resource-Rich Developing Countries, IMF 2012. See also Buffie, E., Berg, A., Pattillo C., Portillo, R., and Zanna, F., 2012, Public Investment, Growth and Debt Sustainability: Putting Together the Pieces, IMF Working Paper 12/144.

24

See C. Papageorgiou and N. Spatafora, 2012, Economic Diversification in LICs: Stylized Facts and Macroeconomic Implications, IMF Staff Discussion Note 12/13; and Sustaining Long-Run Growth and Macroeconomic Stability in LICs: The Role of Structural Transformation and Diversification, IMF 2014.

25

Capacity development consists of training and technical assistance, in which knowledge and best practice is transferred to strengthen institutions. It includes support for the upgrading of fundamentals such as public financial management and financial sector supervision, support for policy decisions such as the choice of tax policy and spending mechanisms, and knowledge transfer on recently developed tools such as modeling for monetary policy or the scaling up of investment. An appropriate balance needs to be struck between the goal of having capacity development focus on the most pressing issues and the goal of having it focus on issues determined by recipient countries.