The Web edition of the IMF Survey is updated several times a week, and contains a wealth of articles about topical policy and economic issues in the news. Access the latest IMF research, read interviews, and listen to podcasts given by top IMF economists on important issues in the global economy.


The Web edition of the IMF Survey is updated several times a week, and contains a wealth of articles about topical policy and economic issues in the news. Access the latest IMF research, read interviews, and listen to podcasts given by top IMF economists on important issues in the global economy.

U.K. Economic Vigor Can Be Bolstered By Stronger Medium-Term Policies

On July 26, U.K. Chancellor of the Exchequer Kenneth Clarke published the concluding statement of the IMF staff’s annual Article IV consultation mission to the United Kingdom. Clarke took this step in the interest of enhancing the openness of the relationship between the IMF and its member countries; he indicated that conclusions of future IMF missions would also be released. “The frank, independent advice we receive each year from the IMF is one of the key benefits of our membership,” Clarke said. Following is a summary of the IMF staff’s latest review of U.K. policies.

United Kingdom: Main Economic indicators

article image

Official forecasts.

Fourth quarter.

May 1996.

Fiscal year beginning April 1; excludes privatization.

July 1996.

Data: U.K. authorities and IMF staff estimates

The United Kingdom’s recent economic performance is “enviable,” with the strong overall performance attributable to “sound economic policies,” according to the IMF staff. The unfettering of market forces, initiated in the 1980s, and the medium-term and stability-oriented focus of fiscal and monetary policy in recent years have underpinned the country’s success.

Economic prospects are also favorable, with 3 percent or more real GDP growth likely in 1997. Despite stronger growth, inflation is projected to continue declining to an annual rate of 2.5 percent or less by early 1997. And if monetary policy retains its medium-term focus, inflation will remain subdued thereafter.

Recent slippages in fiscal policy need to be addressed, however. Although the public sector borrowing requirement (PSBR) is sharply lower than in previous years, it has veered from its intended medium-term track; it is now projected to reach 4.25 percent of GDP in 1996-97 (excluding privatization receipts), casting doubt on the government’s medium-term financial Strategy. Renewed effort is needed to bring fiscal policy back on track—with the goal of balance for the medium term. This approach would enhance the authorities’ policy credibility, particularly if it were to help establish eligibility for European economic and monetary union (irrespective of how the United Kingdom’s option is exercised in this regard). It would also ease the burden on monetary policy, which can help lower real interest rates and boost investment. Current spending—which represents more than 90 percent of total spending—should bear the brunt of reductions in the PSBR, and there does not appear to be scope for tax cuts in the upcoming budget.

Bolstering the revenue-generating capacity of the U.K. tax system is a priority. Exemptions and preferences have tended to proliferate and proven more costly than expected; greater uniformity of tax treatment would both raise revenues and foster greater efficiency. On the spending side, a more efficient public sector will sustain spending restraint. The government’s expenditure reviews, outsourcing, and the Private Finance Initiative (under which the government sheds its role as direct provider of certain public services) all favor more efficient public services and provide an appropriate springboard for further progress.

The IMF staff does not see scope for further cuts in interest rates. Growth is expected to be strong, partly because of recent income tax cuts and interest rate reductions—interest rates have been cut by 1 percentage point, with much of the effect still in the pipeline. Furthermore, fiscal policy remains to be brought back on track. Indeed, higher interest rates will be needed as signs of accelerating growth accumulate.

The government’s structural policies—notably, privatization, labor market reforms, and deregulation—have enhanced the United Kingdom’s economic performance and prospects and contributed to its exceptionally strong record in attracting foreign direct investment. The transformation of the U.K. labor market has also been striking. The IMF staff shares the positive assessment of the Organization for Economic Cooperation and Development that current active labor market programs, which emphasize job search, are a cost-effective way to reduce long-term unemployment. If macroeconomic policies foster medium-term stability and a favorable investment climate, these structural reforms offer a genuine prospect of improvement in U.K. growth over the longer term.

Recent IMF Publications

Working Papers ($7.00)

96/49: Infrequent Large Nominal Devaluations and Their Impact on the Futures Prices for Foreign Exchange in Brazil

96/50: Estimation of the Near Unit Root Model of Real Exchange Rates

96/51: Credit and Exchange Rate-Based Stabilization

96/52: Budget Deficits and Budget Institutions

96/53: Implications of a Surge in Capital Inflows: Available Tools and Consequences for the Conduct of Monetary Policy

96/54: Have North-South Growth Linkages Changed?

96/55: Money Laundering and the International Financial System

96/56: Multiple Exchange Rates, Fiscal Deficits, and Inflation Dynamics

96/57: Moderate Inflation in Poland: A Real Story

96/58: What Determines the Current Account? A Cross-Sectional and Panel Approach

96/59: An Empirical Analysis of Fiscal Adjustments

96/60: Fiscal Rules and the Budget Process

96/61: Fiscal Transition in Countries of the Former Soviet Union: An Interim Assessment

96/62: Broad Money Demand and Financial Liberalization in Greece

96/63: Bank-by-Bank Credit Ceilings: Issues and Experiences

96/64: Worldwide Military Spending, 1990-95

96/65: Inflation Targeting: Theory and Policy Implications

96/66: Macroeconomic Implications of Money Laundering

96/67: Equivalence of the Production and Consumption Methods of Calculating the Value-Added Tax Base: Application in Zambia

96/68: FEERs and Uncertainty: Confidence Intervals for the Fundamental Equilibrium Exchange Rate of the Canadian Dollar

96/69: Does the Gap Model Work in Asia?

96/70: Fiscal Adjustments in OECD Countries: Composition and Macroeconomic Effects

96/71: Recent Trade Policies and an Approach to Further Reform in the Baltics, Russia, and Other Countries of the Former Soviet Union

96/72: The Effects of the European Economic and Monetary Union (EMU) on National Fiscal Sustainability

96/73: The Case for Accrual Recording in the IMF’s Government Finance Statistics System

96/74: Pension Reform in Belgium

96/75: Why Is China Growing So Fast?

96/76: Generational Accounts, Aggregate Savings, and Intergenerational Distribution

96/77: The Role of Labor Market Rigidities During the Transition: Lessons from Poland

96/78: Budget Processes and Commitment to Fiscal Discipline

96/79: The Efficiency of VAT Implementation: A Comparative Study of Central and Eastern European Countries in Transition

Papers on Policy Analysis and Assessment ($7.00)

96/6: Regulatory and Tax Treatment of Loan Loss Provisions

96/7: Fiscal Dimensions of EMU

Publications are available from Publication Services, Box XS600, International Monetary Fund, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430; fax: (202) 623-7201; Internet:

For information about the IMF on the Internet—including SDR exchange rates of 45 currencies—please visit our gopher site (gopher://

Transition Economies Need to Reform Social Safety Nets Social Protection in Transition Economies

Social safety nets throughout Eastern Europe, the Baltic countries, and the newly independent states of the former Soviet Union are under severe strain as a result of weakened financial and administrative capacity. These trends have affected both the revenue base of social protection programs and the ability of these countries to target social benefits. A recent IMF study by Ke-young Chu and Sanjeev Gupta maintains that a solution to this problem will require the following steps:

• reform eligibility and benefits standards governing the distribution of social benefits;

• enhance revenue powers to expand the reach of the tax net, including the payroll tax;

• strengthen budgetary expenditure disciplines and increase the efficiency of public expenditure and social welfare protection programs; and

• incorporate effective targeting mechanisms into the provision of benefits.

The Problem

The former centrally planned countries undergoing economic transition have experienced a sharp decline in output, income, and employment in recent years. This has resulted in severe hardships for many households, particularly the elderly, young children, and the unemployed. The plight of these households has been further aggravated by extraordinarily high rates of inflation.

In this adverse climate, transition countries now face the challenge of securing adequate resources for social protection. But the ability of governments to help is undermined by severe financial and administrative constraints. While the shrinking formal sector, for example, aggravates governments’ difficulties in mobilizing resources, the expanding informal sector makes it increasingly difficult for the authorities to identify the poor or administer targeted social protection programs, according to Chu and Gupta.

Unemployment and Underemployment.

The collapse of output has drastically reduced labor demand—increasing open unemployment in some countries and underemployment in others. While registered unemployment throughout the region is low, total employment has declined. In Russia, for example, total official employment dropped to about 67 million by 1995, from 74 million in 1991. The workers who have vanished from the official employment statistics, explain Chu and Gupta, have either dropped out of the labor force, become unemployed, or entered the informal sector.

The absence of normal labor market adjustment mechanisms in transitional economies further complicates the employment situation. For example, despite diminishing work opportunities in the formal sector, large numbers of employees choose to stick with their traditional employers in order to hold onto company-provided housing, education, and health benefits; an additional incentive to stay put is the inadequacy of unemployment compensation.

Financial Constraints. Prior to the onset of reform, the governments of centrally planned economies controlled virtually all prices and wages; guaranteed employment for all, at least in principle; and provided universal public pensions, child allowances, and other benefits for sickness, maternity, and childbirth. But since the early 1990s, outlays for social protection in transition countries have come under increased financial pressure since revenue from payroll taxes—a traditional source of funding for such programs—began to fall. Other sources of financial weakness are traceable to the growth of the informal sector, the payment of partial wages, and weakened tax administration.

An important factor behind the expenditure squeeze in transition countries is weak revenue performance. As a result, the revenue-to-GDP ratio has declined in many of these countries. This narrowing of the tax base can be traced to such factors as the growth of the informal sector and payment of partial wages and unpaid leave.

Efforts to avoid high payroll taxes are a special concern of the authorities in many transition countries because these taxes create incentives for employers to shift some components of labor compensation out of the wage fund, which forms the payroll tax base. As a result, in many cases payment is made in kind, or in the form of enterprise shares. Low statutory retirement ages for men and women have further reduced the number of working-age individuals who can contribute payroll taxes; this, in turn, has contributed to a worsening of the financial position of pension funds.

Distorted Benefits Structure. Transition economies have so far been unable to overcome protests of higher income groups against the adoption of a more clearly targeted and progressive approach to the provision of social benefits. Combined with dwindling resources, such opposition has helped cause the average pension or cash compensation for the truly needy to decline. In Armenia, for example, recent efforts to assist the poor have been undermined by the absence of targeting mechanisms.

Paradoxically, a number of these countries still provide generous services with loose eligibility requirements, running the gamut from housing benefits to subsidized vacations. In other instances, laws continue to allow retirees to receive full pensions while holding down another job.

Information Deficiencies. Serious information gaps likewise undermine government efforts to manage scarce social resources. This is because transition countries lack reliable data on such crucial variables as employment and unemployment, the number of people receiving social benefits, or the number of enterprises that are expected to pay payroll taxes. And the expansion of the informal sector has made the job of identifying the poor increasingly difficult.

Photo Credits: Padraic Hughes and Denio Zara for the IMF, pages 264, 265, and 268; Tony Stone Images, page 276.


Total Social Protection Outlays in Selected Transition Countries, 1992–941

(Percent of GDP)

Citation: IMF Survey 25, 001; 10.5089/9781451937442.023.A016

1Includes outlays on explicit consumer subsidies, pensions, unemployment benefits, and child and other allowances.2Data for Latvia and Ukraine are for 1995.Data: IMF staff estimates based on data provided by the authorities

Feasible Solutions

Given financial and administrative limitations, Chu and Gupta recommend a minimal benefits package targeted to a growing number of truly vulnerable households in transition economies. Such a strategy would require the following steps:

Reforming eligibility and benefit structures. Necessary reforms in this area include raising statutory retirement ages, rescinding the system of special pensions, and reducing pensions for working retirees. Under the new system, individuals would be required to vacate their last job on reaching retirement age.

Limited progress along these various fronts has already been made. To bring it into conformance with international standards, Estonia, for example, has been raising the statutory retirement age by annual increments of six months to achieve the eventual goal of 65 for men and 60 for women. But even with these changes, Estonia still provides early pensions and credits time spent studying at the university toward pension eligibility.

A reformed benefits structure must also take into account the decline in formal sector employment and the growing importance of informal sector activity. Once established, such a structure would accomplish three purposes: create a more equitable distribution of social adjustment burdens across different population groups, generate additional resources for social protection, and increase the availability of social benefits to informal and private sector workers as well as the unemployed.

Mobilizing financial resources. Measures that could be taken include: First, broaden the tax base to include presently untaxed elements of labor compensation. Unless this is done, the payroll tax base will continue to erode.

Second, enforce more vigorously the registration of new enterprises in order to expand financing for social protection. Taking such a step would help increase financing for social protection by expanding the payroll tax base; strengthen the coverage of workers in the unregistered sector; and make it possible for the tax base to generate additional sources of revenue, such as the value-added tax.

Third, increase the efficiency of expenditures in government programs, including outlays for social protection, and prioritize them.

Reducing administrative burdens. Difficulties in tracking incomes and growing informal sector activity require effective targeting mechanisms for the provision of benefits. The unemployed, for example, could be offered work on public construction projects, in return for which they would receive food or limited amounts of cash. Another possibility might involve targeting housing subsidies to especially needy groups, such as single pensioners.

The Road Ahead

Financial and administrative constraints are placing severe strains on the social welfare budgets of transition economies. A rapidly shrinking revenue base threatens to undermine the ability of these governments to provide the most basic pension benefits. Macroeconomic stabilization and successful reform depend on a decisive response to this crisis, conclude Chu and Gupta. To meet the challenge, the authorities will need to make substantial progress in restructuring the existing system of social benefits, improve payroll tax collection, and achieve a more effective and equitable means of targeting social benefits to the truly needy.

Social Protection in Transition Countries: Emerging Issues, by Ke-young Chu and Sanjeev Gupta, is No. 96/5 in the IMF’s Papers on Policy Analysis and Assessment (PPAA) series. Copies are available for $7.00 from Publication Services, Box XS600, International Monetary Fund, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430; fax (202) 623-7201; Internet:

Harnessing Macro Policy Instruments to Strengthen the Global Environmental Effort

Recognizing that damage to the environment and depletion of the world’s natural resources can have a direct bearing on economic growth—both at the national and the international level—the IMF began considering the impact of macroeconomic policies on the environment and the impact of environmental policies on the macroeconomy in early 1991. As IMF First Deputy Managing Director Stanley Fischer noted at an IMF-sponsored seminar on the environment in May 1995 (see box, page 265), excessive exploitation of natural resources can give rise to structural balance of payments problems and reduce economic growth prospects. The IMF has thus been seeking to improve its understanding of the interrelationships between macroeconomics and the environment in its work with member countries. Two internal IMF studies—by Ronald T. McMorran and Dale Chua, both of the IMF’s Fiscal Affairs Department—look at the scope for economic instruments in helping to preserve both the domestic and the global environment.

Cleaning Up on the Home Front

In his study, McMorran explores the scope for domestic policy reforms aimed at mobilizing resources to finance sustainable development while at the same time helping to lessen environmental degradation and natural resource depletion. The root cause of environmental degradation, says McMorran, is market or policy failure that leads to the underpricing of environmental resources. Underpricing can occur for several reasons, including in particular:

• government policy interventions that sever the link between consumer prices and producer costs;

• failure to introduce policies ensuring that producers and consumers recognize the private and environmental costs of their actions; and

• natural resource fiscal regimes that do not adequately capture rents that accrue to natural resource extracting and harvesting firms.

To be effective and appropriate, reforms must satisfy two criteria. First, they must help improve the fiscal balance, thereby enhancing the government’s capacity to undertake sustainable development policies and programs. Second, the reforms should serve both the environment and the economy by ensuring that environmental and natural resources are used efficiently. McMorran identifies three broad areas of policy reform that satisfy these criteria:

• subsidy reforms;

• pollution taxes; and

• reform of natural resource fiscal regimes.

Subsidies. A subsidy is any government assistance that is extended either to producers—in the form of higher returns than suggested by competitive market outcomes—or to consumers—in the form of goods and services priced below their economic costs. Some subsidies can be justified on efficiency or equity grounds. But because they sever the link between consumer prices and producer costs, subsidies result in an inefficient allocation of resources that can lead to lower growth as resources are diverted from areas where their marginal productivity is highest.

Subsidy policies tend to be a chief source of policy failure that then encourages environmentally damaging activities. Correcting for policy failure by reforming subsidies can help reduce environmental damage and improve growth prospects by ensuring a more efficient allocation of resources. Subsidy reforms can also reduce or eliminate a major drain on government funds, thereby improving the fiscal balance and freeing up resources that the government can use to pursue sustainable policies and programs.

Distortionary subsidies are costly to government budgets, McMorran notes. Budgetary subsidies to businesses during 1975–90 averaged 2.5 percent of GDP for all countries; over the same period, total subsidies and transfers from central governments accounted for approximately 11 percent of GDP for all countries. Although not all subsidies are questionable on efficiency grounds, the potential of subsidy reforms to realize budgetary savings, lessen environmental damage, minimize waste, and ensure a more efficient allocation of resources could be substantial. For example, it has been estimated that in the energy sector, subsidies for fossil fuels total more than $210 billion, accounting for 20-25 percent of the value of fossil fuel consumption at world prices; removal of these subsidies would reduce global carbon emissions by 7 percent. Similar examples can be drawn from the electricity industry and the agricultural sector.

Pollution Taxes. This policy instrument has a potential both for lessening pollution and for providing a tax handle for raising revenue. Pollution taxes take two forms: either on discharges into the environment (Pigouvian tax), or on productive inputs or products that are linked to pollution-induced environmental degradation (indirect environment tax).

In theory, a Pigouvian tax provides the most efficient means of internalizing the costs of emissions. It raises the price of pollution to reflect social cost, thus ensuring that polluters absorb both the private and the social costs of their actions. Dynamic efficiency gains arise because the tax provides incentives for firms to adopt new technology to lower costs.

Despite their theoretical efficiency, in practice, Pigouvian taxes are subject to considerable design, implementation, and administrative problems. For this reason, and also because it is often easier to tax goods that are linked to environmental damage than to tax the damage itself, indirect environment taxes are frequently suggested as a second-best alternative. By taxing productive inputs (for example, through a carbon or energy tax) or consumption goods (for example, plastic bags or disposable containers) whose use is linked to environmental damage, indirect taxes provide price incentives for producers and consumers to change their emissions behavior to achieve the socially efficient level of emissions. Unlike Pigouvian taxes, however, indirect environment taxes do not encourage abatement of environmental damage at the least social cost.

Among countries that have introduced pollution taxes, the use of Pigouvian taxes has been confined mainly to Europe. The economies in transition to market-oriented systems are among the most advanced users of this tax—for example, Estonia, Hungary, Poland, and Russia all impose taxes on air and water emissions. Indirect environment taxes have been implemented more widely, but, in general, only by industrial countries.

Despite their potential, pollution taxes have not been wholly effective for at least three reasons:

• The rates are set so that the cost of paying the tax is often less than the cost of abatement. To be effective, the rates must be set at levels high enough to encourage firms to invest in pollution control equipment or other means of reducing pollution.

• Existing pollution taxes have been ineffective in encouraging state-owned enterprises to abate pollution. With soft budget constraints and protection from the risk of bankruptcy, these enterprises will not be responsive to price signals created by environment taxes. In many countries, moreover, state-owned enterprises dominate some of the most pollution-intensive sectors.

• The objectives of the taxes are confused. Few environment taxes are designed for the express purpose of internalizing the social costs associated with pollution-induced environmental degradation. In most cases, the taxes have been introduced for reasons other than to provide market incentives for economic agents to take environmental costs into account—for example, in Estonia, Hungary, Poland, and Russia, the main role of these taxes is to raise revenues for extrabudgetary environmental funds.

Natural Resource Fiscal Regimes. The taxation of economic rents that accrue to firms from extraction and harvesting operations is appealing from a fiscal policy perspective. These rents—the difference between the price of a resource and the cost of extracting it (including a profit margin)—are generated because of the scarcity of resources and because of variable extraction costs. In theory, these rents can be captured without imposing efficiency costs on the extraction and harvesting firms because the firms can still be profitable, even if all rents are taxed and transferred to the government.

Poorly designed fiscal systems, however, can provide incentives for inappropriate operations, leading to excessive extraction or harvesting. Under-pricing of concessions and leases, for example, provides incentives for firms to hoard natural resource lands, treating them as free goods, holding them for speculation, and managing them improperly. In addition, low fees—royalties, mineral taxes, stumpage fees—and low collection rates of established fees not only result in loss of revenue to the government, but also encourage extractors and harvesters to waste the resource.

A reform of natural resource fiscal regimes can help mobilize budgetary resources and discourage excessive extraction and harvesting. But, McMorran concludes, the extent to which these fiscal instruments will be exploited depends upon the political, social, and environmental characteristics of individual countries.

Cleaning Up at the Global Level

Global environmental problems call for the mobilization of international resources. In his paper, Dale Chua examines the scope for using economic instruments to lessen global environmental problems and finance their solutions. He also addresses the issue of international cooperation and self-regulation in the context of attaining a globally efficient outcome.

Obstacles. Socially efficient resource allocation requires that all costs and benefits be fully reflected in the use of the resource. The market allocation of global environmental resources is inefficient because, in most cases, costs and benefits relating to the use of these resources escape the price system and spill over to some third party—an individual or group.

Public intervention or bargaining to correct for the misallocation is ineffective at the global level because of the lack of a common ground on which countries can meet to decide on appropriate corrective measures. This problem arises in cases of cross-border pollution as well as in the use of free-access resources.

Three key considerations hinder the search for appropriate instruments to address environmental problems at the global level, according to Chua:

National sovereignty. In a world with diverging domestic interests, only fairly modest international arrangements seem feasible.

Problems of voluntary compliance. Even with strong international cooperation, free riders would remain a problem.

Allocation of environmental targets. For a developing country that regards growth as the only solution to its current economic problems, acceptance of a target—say, for pollution abatement to meet a global warming objective—may impose a binding constraint on economic development.

International Cooperation. Despite domestic social and political factors and the difficulties of allocating targets and enforcing compliance, Chua notes that progress has been made on the international front. In particular, a number of international environmental agreements and conventions have come into force in recent years. These efforts show that signatory countries are willing to accept some cost—such as abiding by global environmental regulations and ceding some authority to an organizing body—as the price for finding some means of achieving an efficient outcome.

The effectiveness of these arrangements in helping to solve large-scale global environmental problems is limited, however. This is because of the inherent dilemma contained in the approach: to be effective, international arrangements must have wide powers (to levy corrective taxes, for example); but to be widely acceptable, no arrangement can ask too much of any signatory country at the risk of losing participants. Existing arrangements are therefore limited in scope; signatory countries are not asked to make drastic adjustments to their existing domestic policy, or to reduce economic activities in an important sector, or to transfer domestic tax revenues to the international body created by the arrangement.

IMF Publishes Proceedings of Seminar On the Environment

Macroeconomics and the Environment, edited by Ved P. Gandhi, Assistant Director in the IMF’s Fiscal Affairs Department, is a compilation of the proceedings of a seminar sponsored by the IMF in Washington in May 1995 (see IMF Survey, June 5, 1995, page 172, for a summary). The seminar, which followed one held in May 1993, was held with four specific objectives in mind:

• to make IMF staff aware of the current research on macroeconomics and the environment;

• to present work being done on the environment by IMF staff in support of the mandate and primary functions of the organization;

• to assess the feasibility of integrating macroeconomic and environmental policy formulation in IMF member countries at different stages of development; and

• to identify the main elements of work that the IMF staff can possibly undertake in the future.

Participants included experts from academic and research institutions, nongovernmental organizations, the World Bank, and the IMF.

Macroeconomics and the Environment, edited by Ved P. Gandhi, is available for $22.50 from Publication Services, Box XS600, International Monetary Fund, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430; fax: (202) 623-7201; Internet:

Another approach that offers a more realistic way to address the political and incentive constraints inherent in the international agreements is the Global Environment Facility (GEF). The GEF, established in November 1990 by the World Bank, the United Nations Development Program, and the United Nations Environment Program, provides grants and concessional funds to developing countries for protecting the global environment. The GEF’s performance so far has been encouraging, according to Chua. It is acceptable to participating nations because it does not impinge on national sovereignty; in particular, it avoids intruding into the area of taxation, and its financing is based on burden sharing. Also, because the GEF does not allocate international environmental targets that could set physical limits on growth, it does not ask that developing countries directly sacrifice their economic growth aspirations. Poorer countries are therefore willing to participate in cleaning up the environment to the extent that adequate financing can be found for projects that benefit the international community at large.


IMF Technical Assistance: November 1995–April 1996

(in person years)

Citation: IMF Survey 25, 001; 10.5089/9781451937442.023.A016

Note: IMF technical assistance is conducted under the IMF’s own grant resources and through financing arrangements with the United Nations Development Program, the World Bank, the European Union, the Japanese Government, and other donors.1Including legal and computer services.

During November 1995—April 1996, 125 person years of technical assistance were delivered by IMF staff, long- and short-term experts, and on seminars and workshops (excluding IMF headquarters seminars provided by the IMF Institute).

Recent developments in November 1995-April 1996 included:

• IMF technical assistance delivery—after a period of rapid growth in the early 1990s—stabilizes at around 300 person years in FY 1996;

• renewed emphasis on improving quality and relevance of technical assistance through enhanced monitoring and evaluation;

• continued strong multilateral and bilateral donor interest in cooperating with IMF in providing technical assistance to strengthen economic and financial management; and

• in-country reviews of joint IMF/UNDP technical assistance programs completed for Angola, Cambodia, Namibia, the South Pacific region, and Vietnam.

Data: IMF Technical Assistance Committee

The GEF could also, Chua suggests, be used to mobilize new resources by exploring additional areas of activity, including:

Engaging the private sector, by finding ways to expand its financing to cover more private sector projects; extending its resources to assist small or medium-sized enterprises for environmental projects that have global benefits; and seeking new contributions from industries that would be most adversely affected by global environmental degradation.

Promoting the transfer of clean technology from developed to developing countries and serving as a conduit for the exchange of environmental knowledge between these countries.

Fostering additional interaction with the international environmental arrangements, by lending further support to their implementation and being involved in presenting strategy statements on how to facilitate the attainment of common objectives.

Financing Mechanisms. Global taxes to finance global environmental efforts represent another approach to solving the world’s environmental problems. Even if technically feasible, however, these taxes may not be readily accepted in the foreseeable future, Chua acknowledges. There is currently little willingness on the part of many governments to cede sovereign taxation power to an international body.

According to Chua, a few global taxes, such as a global carbon tax, and user charges (for example, on international waters, the ozone layer, space orbits, and biodiversity) could induce more efficient use of the global environment—but only if nations were willing to accept some loss of fiscal sovereignty. Revenues raised through such global taxes and user charges could be earmarked for a special global trust fund that could be used to finance projects to help reclaim the global commons from past damage. Resources so mobilized could also be earmarked for the development of new technologies that could minimize the adverse environmental impact associated with the future use of the global commons.

Given the unlikelihood that national governments will agree in the near future to cede any of their fiscal authority, however, the scope for global taxes and user charges to control international environmental problems is limited. Instead, concludes Chua, the best strategy for raising resources to foster global environmental security would be to direct efforts toward seeking cooperation from national governments to commit and contribute more generously to the GEF and to encourage private sector participation in the mobilization of resources.

Enhanced Reform Can Give Momentum To Ukrainian Economy

On July 9 at IMF headquarters, the IMF and the World Bank hosted a joint seminar on Ukraine’s transition to a market-oriented economy. The event provided a unique opportunity to evaluate and discuss credible macroeconomic adjustment and systemic reforms in Ukraine within the context of the IMF’s and the World Bank’s role in that country. Presentations were delivered by staff members of both the IMF and the World Bank, followed by comments from a visiting delegation from Ukraine and representatives from other international institutions, research institutes, and the academic community.

Future economic success in Ukraine requires the full implementation of the medium-term macroeconomic stabilization and reform program—with particular emphasis on structural issues, seminar participants agreed. Notwithstanding the formidable challenges facing Ukraine, there was a clear consensus that the country had reached a potentially critical point in its transformation from a centrally planned to a market-oriented economy. Participants therefore urged Ukraine’s authorities to accelerate privatization, modernize and liberalize the conduct of trade policy, establish an effective legal system to safeguard Ukraine’s emerging private sector, and rationalize fiscal policy through the development of a well-targeted social safety net.

In his introductory remarks, Stanley Fischer, First Deputy Managing Director of the IMF, praised Ukraine for the solid progress it had made in combating inflation and maintaining a stable exchange rate. The most pressing order of business facing Ukraine over the medium term, he said, was structural reform—beginning with the development of a viable framework of market-based laws and practices. Trade policy constituted another area ripe for structural reform, said Fischer. Caio Koch-Weser, Managing Director of Operations of the World Bank, noted that those countries that started late on the transition path, such as Ukraine, had nevertheless made encouraging progress. Privatization, he said, constituted a key challenge facing them over the next few years.

Medium-Term Challenges

Atish Ghosh of the IMF led off with a presentation on Ukraine’s medium-term economic outlook. In view of Ukraine’s low investment rate, sharply falling consumption, and high taxes, he voiced support for efforts to jump-start the economy through increased private and public investment financed mainly by external borrowing. David Orsmond of the IMF credited Ukraine’s authorities for the progress they had made in reducing the country’s fiscal deficit. But additional fiscal reforms were necessary. The first requirement should be a major reduction in the payroll tax along with efforts to ensure that Ukraine’s nascent private sector contribute its fair share of revenues. Jonathan Dunn and Patrick Lenain, also of the IMF, urged strict adherence to conservative monetary policy—to rebuild confidence and help increase demand for money. Such a stance, they maintained, would provide a vital impetus to the growth process.

Labor Markets and Social Safety Nets

Commenting on the labor market, Michelle Riboud of the World Bank observed that Ukraine was characterized by low official unemployment, a highly compressed wage structure, and an excessively high payroll tax. A substantial part of the workforce—concentrated in the farming and informal sectors—is currently not subject to taxes and should be, she said. Ukraine’s poor, added Tom Hoopengardner of the World Bank, are largely confined to extended families and the elderly. While reducing the poverty rate promised to be difficult, he said, higher growth and reform of the social benefits system were prerequisites. Elliott Harris of the IMF recommended that government efforts to overhaul Ukraine’s safety net begin with pension reform: years paid into the system, not years of service, should be the basis upon which benefits are calculated. For budgetary reasons, Harris added, the granting of early pensions—before the present statutory ages of 60 for men and 55 for women, which themselves are low by international standards—should be eliminated where possible.

Reform and Governance

In a luncheon address, Vito Tanzi, Director of the IMF’s Fiscal Affairs Department, spoke on how good governance, by helping to root out corruption and rent-seeking activities, can play a significant role in promoting economic reform. Addressing corruption in transitional countries nevertheless posed special problems, where the very process of reducing the state’s role in the economy had created significant opportunities over the short run for illicit financial gain. He also stressed the need for a higher degree of budgetary transparency and hard budget constraints. He further emphasized that the widespread use of regulations as substitutes for fiscal policy and of quasi-fiscal activities obscured the stance of fiscal policy. Another crucial step toward good governance and reduced corruption, said Tanzi, was a well-trained, highly ethical civil service. But perhaps the most necessary and fundamental step promotive of good governance over the medium term would be to weaken the state’s hold on economic activity—through privatization, deregulation, and price liberalization.

A Private Sector Focus

Ukraine has registered marked progress in establishing a vibrant private sector, said Bernard Drum of the World Bank, notably in the areas of small-scale privatization and the development of capital markets. The authorities, however, needed to demonstrate a greater political resolve to ensure the success of Ukraine’s existing privatization program.

Despite progress in creating a modern system of supervision and prudential control, Julio Jiménez of the IMF indicated that Ukraine’s current system of banking laws continued to be plagued by major deficiencies. Among the key weaknesses he identified were the National Bank’s inability to close insolvent banks and the absence of a legal system to facilitate debt recovery. Once people regained their faith in the banking system, however, Jimenez predicted that savings would increase and hidden dollars would return to the banking system.

Peter Cornelius of the IMF addressed the role of competition policy in Ukraine. Although encouraging progress had been made in economic stabilization and liberalization since late 1994, Cornelius said additional steps were needed to unleash the country’s growth potential—beginning with an appropriate framework for an emerging private sector. Necessary steps toward this goal would need to include deregulation, removing administrative controls, and facilitating the start-up of new businesses. Galina Mikhlin-Oliver and Sandra Bloemenkamp, both of the World Bank, followed with an overview of Ukrainian law. The most pressing task facing the authorities, they said, was the establishment of a new civil code to guarantee the integrity of contracts and property rights.

Trade Policy and Sectoral Reforms

Revitalizing Ukraine’s agricultural sector is a long-term process, cautioned Richard Burcroff II of the World Bank. It was a disservice—if not unrealistic and destabilizing—to raise hopes for a miracle recovery. Resuming near-term growth would require a series of steps, including a deepening and extension of necessary policy reforms to encourage greater productivity and efficiency. Turning to energy, Lazlo Lovei of the World Bank called for the liberalization and proper regulation of fuel and energy prices through the elimination of price subsidies and investment grants.

Despite the sharp contraction in trade that took place after independence, Ukraine continues to be a relatively open economy, observed Alan MacArthur of the IMF. The key objective of trade reform in Ukraine, he said, is to support the overall goal of rapid, sustainable, outward-oriented growth. This would require further liberalization of the trade regime, which would help establish a rational set of relative prices for traded goods, while limiting distortions owing to monopolistic pricing, thus increasing efficiency and welfare.

Roundtable Discussion

The seminar concluded with a roundtable discussion between Daniel Kaufmann of the World Bank and Alex Sundakov of the IMF, with John Odling-Smee, Director of the IMF’s European II Department, moderating. Notwithstanding Ukraine’s negative growth record, Kaufmann maintained that the emergence of a large and vibrant unofficial economy had laid the foundations for sustained growth in coming years. Sundakov cautioned, however, that Ukraine’s reform effort continued to be hobbled by the absence of far-reaching institutional reform. He noted, for example, that under Ukraine’s multilayered policymaking system, various branches of government produced a large quantity of legislative and quasi-legislative documents that were not only poorly coordinated but also frequently unpublicized.

The Ukrainian participants responded that shortcomings in the government’s decision-making and coordinating functions could be partially remedied by more targeted IMF and World Bank technical assistance to boost the performance of individual ministries, particularly in the budgetary arena.

From the Executive Board

Kazakstan: Article VIII

The government of the Republic of Kazakstan has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4, of the IMF Articles of Agreement, with effect from July 16, 1996. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 129 countries have now assumed Article VIII status.

Two of the purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade and thereby to contribute to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members and oversees the elimination of exchange restrictions that hamper the growth of world trade.

By accepting the obligations of Article VIII, Kazakstan gives confidence to the international community that it will pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions and thereby contribute to a multilateral payments system free of restrictions.

Kazakstan joined the IMF on July 15, 1992. Its quota is SDR 247.5 million (about $360 million).

Press Release No. 96/41, July 23

Tanzania: Article VIII

The government of Tanzania has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4, of the IMF Articles of Agreement, with effect from July 15, 1996. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 130 countries have now assumed Article VIII status.

Two of the purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade and thereby to contribute to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members and oversees the elimination of exchange restrictions that hamper the growth of world trade.

By accepting the obligations of Article VIII, Tanzania gives confidence to the international community that it will pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions and thereby contribute to a multilateral payments system free of restrictions.

Tanzania joined the IMF on September 10, 1962. Its quota is SDR 146.9 million (about $214 million).

Press Release No. 96/42, July 25

Central African Republic: Article VIII

The government of the Central African Republic has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4, of the IMF Articles of Agreement, with effect from June 1, 1996. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 131 countries have now assumed Article VIII status.

Two of the purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade and thereby to contribute to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members and oversees the elimination of exchange restrictions that hamper the growth of world trade.

By accepting the obligations of Article VIII, the Central African Republic gives confidence to the international community that it will pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions, and thereby contribute to a multilateral payments system free of restrictions.

The Central African Republic joined the IMF on July 10, 1963. Its quota is SDR 41.2 million (about $60 million).

Press Release No. 96/43, July 29

Comoros: Article VIII

The government of Comoros has notified the IMF that it has accepted the obligations of Article VIII, Sections 2, 3, and 4, of the IMF Articles of Agreement, with effect from June 1, 1996. IMF members accepting the obligations of Article VIII undertake to refrain from imposing restrictions on the making of payments and transfers for current international transactions or from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval. A total of 132 countries have now assumed Article VIII status.

Two of the purposes of the IMF, as stated in its Articles of Agreement, are to facilitate the expansion and balanced growth of international trade and thereby to contribute to the promotion and maintenance of high levels of employment and real income; and to assist in the establishment of a multilateral system of payments in respect of current transactions between IMF members. In seeking to achieve these objectives, the IMF exercises firm surveillance over the exchange rate policies of its members and oversees the elimination of exchange restrictions which hamper the growth of world trade.

By accepting the obligations of Article VIII, Comoros gives confidence to the international community that it will pursue sound economic policies that will obviate the need to use restrictions on the making of payments and transfers for current international transactions and thereby contribute to a multilateral payments system free of restrictions.

Comoros joined the IMF on September 21, 1976. Its quota is SDR 6.5 million (about $9.5 million).

Press Release No. 96/44, July 29

Estonia: Stand-By

The IMF approved a 13-month standby credit for Estonia for an amount equivalent to SDR 14 million (about $20 million) in support of the government’s 1996–97 economic program. The Estonian authorities do not intend to use the credit except in the unlikely event that an unexpected balance of payments need were to emerge.

During 1995 and 1996, Estonia has made further progress toward becoming a modern market economy. After stagnating in 1994, the economy expanded in 1995, with real GDP growth of 3.2 percent; inflation declined to 28.9 percent in 1995 from 47.7 percent in 1994; and the external current account deficit narrowed to 5.3 percent of GDP in 1995 from 7.5 percent in 1994 and was financed mainly by direct foreign investment. This performance meant that Estonia broadly met the objectives of the 15-month IMF stand-by credit approved on April 12, 1995, under which no drawings were made (see Press Release No. 95/23, IMF Survey, May 8, 1995).

Estonia: Selected Economic Indicators

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Data: Estonian authorities and IMF staff estimates

Structural reforms broadened in 1995, particularly in the privatization of medium- and large-scale enterprises and housing, and in the development of a sound financial system equipped to address the needs of an emerging market economy. The regulatory environment for domestic financial institutions improved further and the government maintained a highly open trade regime.

Despite these accomplishments, the economic recovery and progress toward price stability are likely to remain fragile for some time. Furthermore, financial imbalances appeared in late 1995, as a decline in public savings led to a general government deficit and to increased reliance on foreign borrowing for public investment.

The 1996-97 Program

The economic and financial program for 1996–97, which is supported by the new stand-by credit, seeks to strengthen the economic recovery while preserving macroeconomic stabilization. The program aims at achieving real GDP growth of 3.1 percent in 1996 and 4.4 percent in 1997; reducing inflation to about 27 percent in 1996 and 21 percent in 1997; and containing the external current account at 6.9 percent of GDP in 1996 and 5.8 percent in 1997.

To these ends, fiscal policy aims to ensure that government operations do not generate excessive pressures on prices and wages and do not crowd out private sector access to domestic and external financing. Accordingly, the overall deficit of the general government will be limited to 1.4 percent of GDP in 1996 and 0.5 percent of GDP in 1997. Total revenues will be maintained at 38.7 percent and 38.2 percent of GDP in 1996 and 1997, respectively. Expenditure and net lending are projected to decline to 40.1 percent of GDP in 1996 and 38.7 percent in 1997. Current and capital expenditure and net lending will contribute about half of the decline in the expenditure ratio in 1996, while the fiscal adjustment is expected to fall entirely on current expenditures on goods and services in 1997. In the exchange area, Estonia will continue with its strict currency board arrangement, with the result that there is essentially no room for an active monetary policy.

Structural Policies

Under the program, a number of structural changes in the fiscal management system will be implemented, including steps to improve the control and monitoring of borrowing by local governments, as well as the efficiency of government expenditure. Both bank restructuring and strengthening of bank supervision are expected to continue under the program. Residual privatization in the program period and beyond will focus on industrial monopolies—in particular, the electricity company—as well as on the oil shale sector and land privatization.

Social Safety Net

Estonia’s social safety net includes unemployment compensation and a targeted income maintenance scheme. New pension and social tax laws aimed at establishing a more direct link between contributions and benefits and a sharing of contributions between employers and employees will be submitted to Parliament by November 1996.

The Challenge Ahead

Adherence to its coherent economic strategy is essential to pre-empt the emergence of macroeconomic imbalances in Estonia and to attain the growth and disinflation objectives in 1996, 1997, and the medium term.

Estonia joined the IMF on May 26, 1992, and its quota is SDR 46.5 million (about $68 million). Its outstanding use of IMF financing currently totals SDR 59 million (about $86 million).

Press Release No. 96/45, July 29

Selected IMF Rates

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The SDR interest rate, and the rate of remuneration, are equal to a weighted average of interest rates on specified short-term domestic obligations in the money markets of the five countries whose currencies constitute the SDR valuation basket (the U.S. dollar, weighted 39 percent; deutsche mark, 21 percent; Japanese yen, 18 percent; French franc, 11 percent; and U.K. pound, 11 percent). The rate of remuneration is the rate of return on members’ remunerated reserve tranche positions. The rate of charge, a proportion (currently 109.4 percent) of the SDR interest rate, is the cost of using the IMF’s financial resources. All three rates are computed each Friday for the following week. The basic rates of remuneration and charge are further adjusted to reflect burden-sharing arrangements. For the latest rates, call (202) 623-7171.

Data: IMF Treasurer’s Department

Is Foreign Investment Making Emerging Markets More Volatile?

Foreign investment in emerging equity markets has grown dramatically in recent years, rising from a scant 0.5 percent of total investment in 1987 to 16 percent in 1993. Shadowing strong interest in emerging equity markets, however, have been questions about the impact of large-scale foreign involvement in less mature markets. Has it been a decidedly mixed blessing, even destabilizing? More broadly, does the widely held perception that foreign money has increased the volatility of emerging markets suggest that the benefits of liberalization by developing countries might have been oversold?

Although industrial country investor interest in emerging markets has surged, research on emerging market behavior has lagged. Relatively little has been published to date, and the short time period for which data are available make conclusions preliminary. An IMF Working Paper by Anthony Richards, an Economist in the European II Department, reviews recent analyses and assesses the extent to which volatility and predictability in investment returns differ between emerging and mature markets.

His findings challenge two widely held perceptions about emerging markets: that they are subject to more frequent and extended deviations from fundamental values than mature markets, and that the presumed increase in volatility is due largely to the influx of highly mobile foreign capital. Richards’ evidence suggests that foreign investment has, if anything, tempered rather than aggravated emerging market volatility. And while there are indications of reversals in returns, these are not significantly greater in magnitude than those experienced in mature markets. These findings, which contradict the widespread impression of rising emerging market volatility, bolster the case for liberalization. Richards cautions, however, that structural reforms may play a crucial role in ensuring that emerging markets are sound when they open themselves to foreign investment.

Short-Term Volatility

Conventional wisdom maintains that emerging market returns have become more volatile in recent years, with the Mexican financial crisis only the largest and most high-profile instance of sharp swings in market behavior. The financial press and several academic commentators have fingered large-scale foreign investment as the most likely suspect. But a number of recent analyses, including that of Richards, find little evidence of increased volatility and no causal link to foreign investor participation in these markets.

Examining monthly data for nine markets during December 1975–September 1995 and weekly data for 16 markets from the end of 1988 to the end of September 1995, Richards discerns little indication of rising volatility in the short-term returns. Smaller industrial countries register consistently higher volatility in short-term returns than their larger industrial country counterparts, and emerging markets, on average, record the highest volatility. But there is little evidence to suggest that the more volatile emerging markets have become even more volatile in recent years when large-scale foreign investment became a prominent player in these markets.

The next issue of the IMF Survey will appear on September 9, 1996.

The weekly data, for example, suggest a statistically significant decrease in volatility for eight countries and a statistically significant increase for only two countries—Colombia and Mexico. The monthly data concur with these findings, and Richards notes that “on average, there seems to be no tendency for an increase in volatility in emerging equity markets, even when the ‘dice are loaded’ by conducting such tests soon after a period when volatility is known to have been especially high.”

But if volatility has not risen—and may have fallen—in emerging markets, why, Richards asks, is the contrary impression so widely and steadfastly held? He suggests several possible answers. Portfolio managers in industrial countries investing in emerging markets for the first time may be reacting to their exposure to the comparatively more volatile emerging markets rather than to increased volatility in these markets. Richards stresses that emerging markets were highly volatile long before foreign investors found them attractive. Or, it may be that as the popularity of emerging market investment increased, so did scrutiny of price movements in these markets. Once again, this suggests that emerging markets have not changed as much as industrial country awareness of them has.

Longer-Term Trends

Tests by Richards and others on short-term returns offer generally robust evidence that emerging market volatility has not increased in recent years. But concern about longer-term trends persists. Developing country policymakers have expressed anxieties about long swings in asset prices followed by large reversals, and some researchers have sounded alarms about the potential for speculative bubbles. These bubbles would be characterized by above-normal “positively autocorrelated” returns (or persistence in relative performance) and then large negative returns when the bubble bursts.

To estimate the potential for longer-term problems, Richards uses several methodologies. Regression analyses yield no firm evidence that emerging market returns are subject to the type of strong reversals indicative of regular long swings or bubbles in asset prices. An alternative approach is the winner-loser methodology, which examines whether markets that have performed well (“winners”) or poorly (“losers”) in one period continue their relative performance in the next period, or whether these trends are reversed.

Richards finds that the initial return differentials between winners and losers are far larger in emerging markets than in mature markets, and greater for small industrial countries than for larger ones—results that mirror the behavior of short-term volatility. Richards finds evidence of positive autocorrelation at shorter-term horizons (three and six months) in all groups of markets, with mature markets demonstrating a degree of autocorrelation comparable to emerging markets. All markets experienced reversals in their returns at longer horizons, but he finds that reversals appear to be larger, and appear more quickly, in emerging markets.

But with regard to the possibility of fads, bubbles, or other such factors in emerging market behavior, the winner-loser analysis suggests that the reversals in emerging markets may well be smaller in relative terms than in some mature markets. Concern over the possibility of return reversals in emerging markets may be somewhat exaggerated, Richards suggests, at least in comparison with the possibility of similar behavior in smaller mature equity markets.

Research Results

As Richards’ short- and long-term tests of emerging market behavior indicate, there is little evidence to support the impression that volatility has increased in these markets in recent years. Emerging markets have always been volatile. While domestic capital may not have been hot—or highly mobile—prior to liberalization, large changes frequently took place in asset prices in these narrow domestic markets. Richards finds at least a tentative conclusion that the presence of foreign investors may have reduced rather than exacerbated volatility, consistent with the expectation that opening these markets allows the risk to be spread and should reduce, not increase, the volatility of returns.

Greater industrial country attention to emerging market price movements should therefore not be confused with greater volatility. And Richards’ findings also caution against ascribing greater influence to foreign investors than is warranted. Domestic investors still play an important role in emerging markets in determining the volatility and level of asset prices. As other research has indicated, supposedly “hot” short-term capital flows may be no more volatile than the supposedly more stable long-term flows.

Richards finds evidence of positive autocorrelation over one or two quarters and weaker evidence of negative autocorrelation thereafter. In interpreting the results of the winner-loser tests, Richards notes that the hypothetical returns to a “contrarian” strategy (of buying in markets that have performed poorly over a two- or three-year period and selling in those that have done well) are economically significant (10 percent a year) but statistically imprecise, given the short data sample available. Such reversals in returns over longer time horizons could be consistent with investor overreaction or fads, Richards notes, but could also reflect differences in risk, or segmentation from the world market. Indeed, he suggests, researchers at this point can do little more than speculate as to the causes. And return reversals in emerging markets should be kept in perspective; they are only moderately larger in absolute terms than those in industrial countries, and may actually be somewhat smaller than those in some mature markets.

The Case for Liberalization

The results of Richards’ analysis bolster the case for liberalization. Open financial markets allow residents and foreigners to benefit from risk diversification and the possibility of shifting consumption between the present and the future. “As risk is spread more widely, smaller changes in asset prices will be required to equalize the demand and supply of risky assets. The required rate of return on domestic projects (that is, the cost of capital) should therefore fall in response to market liberalization,” Richards notes.

Reduced capital controls also promote more efficient asset pricing and intensify demand for higher standards in financial reporting and for legal frameworks more favorable to investment. Growth of stock markets may also increase the volume of long-term investment.

Study Weighs Impact of Institutional Investors in Emerging Markets

Have Institutional Investors Destabilized Emerging Markets? by Brian Aitken, an Economist with the IMF’s European II Department, finds evidence that emerging stock markets as a group have experienced a sharp increase in autocorrelation in total returns since 1991—a period that coincides with large portfolio capital inflows by industrial country institutional investors into these markets. The size and the timing of the observed increase in autocorrelation, he argues, indicate institutional investor sentiment may have played a role in producing the sort of accelerating and collapsing price behavior often associated with speculative bubbles.

One explanation for this behavior, Aitken suggests, is that institutional investors have regarded emerging market stocks as an asset class, as distinct from industrial country stocks or treasury bills. If information on each asset’s fundamentals is costly to obtain, investors interested in diversifying their portfolios into emerging markets might consider past performance of the asset class in evaluating its risk-return characteristics. In this environment, shifts in investor sentiment might at times be self-reinforcing. For example, an initial period of rising emerging stock prices led many institutional investors to regard emerging market stocks as a sensible avenue for portfolio diversification. As more investors diversified, stock prices continued to rise. The resulting high historic rates of return, Aitken says, strengthened the perceived benefits of diversification.

This sort of self-reinforcing behavior, characterized as “trend chasing” or “positive feedback trading,” is destabilizing, possibly resulting in asset price overshooting, cycles of booms and busts, and other irrational market outcomes. Such behavior, Aitken argues, could account for the large observed increase in autocorrelation.

A key result of Aitken’s analysis is that while a sharp increase in autocorrelation is observed for returns in emerging markets as a group, the increase is less pronounced for returns in each individual emerging market. This seemingly paradoxical result reinforces the argument that institutional investors have been treating developing country stocks as a separate asset class. For example, to the extent that portfolio managers randomly spread their holdings over a set of emerging market assets, shifts in investor sentiment toward the asset class would not be uniformly reflected in the price of each individual asset, resulting in less bubble-like price behavior at the level of each individual asset than for the asset class. One implication is that fund managers who perceive their portfolio of emerging market stocks to be underperforming would be more likely to move out of emerging market stocks rather than shift their holdings from one emerging market asset to another.

Aitken concludes that while institutional investors have had a destabilizing influence in emerging markets, the liberalization of these markets and the subsequent entry of institutional investors may simply have replaced large stable structural inefficiencies (in a pre-liberalized market) with smaller, though less-stable, behavioral inefficiencies.

Aitken also finds preliminary evidence that institutional investors have learned from their experience in emerging markets and may now be less willing to treat emerging markets as a single asset class. The pattern of prices beginning to emerge after the Mexican financial crisis suggests that for emerging markets as a whole, prices have been less prone to positive autocorrelation than in 1992-94.

Of course, more open markets are not without possible pitfalls, according to Richards. Excessive capital inflows can lead to an unwarranted exchange rate appreciation, unsustainable current account deficits, and asset price bubbles. And investment in emerging markets can at times be driven more by a perceived lack of opportunities in industrial countries than by sound fundamentals in developing countries. To the extent institutional investors view emerging markets as a single-asset class, shocks in one country or region can also be transmitted throughout emerging markets without an economic rationale.

The overall volatility of emerging markets may not have increased but the nature of price changes in these markets may have. In equity markets closed to foreigners, Richards observes, changes in expectations will affect the domestic currency asset price but may have little impact on most sectors of the economy. Foreign investor participation and fully convertible foreign exchange ensure, however, that the foreign exchange market will also be affected, with a possibly far greater impact on the economy as a whole.

Sound economic policies hold the key to minimizing damaging swings in asset prices and capital flows, concludes Richards. Strong prudential regulation and supervision provide needed support to appropriate policies and help minimize damage should such swings occur. The findings may also suggest, he argues, that gradual liberalization may be appropriate in some cases and that attention to structural reform may be crucial to ensuring that emerging markets have the capacity to absorb the capital inflows they attract. Ultimately, sound policies should ensure that emerging market volatility falls gradually over time to approximate industrial country levels.

Copies of Working Paper 96/29, Volatility and Predictability in National Stock Markets: How Do Emerging and Mature Markets Differ? by Anthony J. Richards, and Working Paper 96/34, Have Institutional Investors Destabilized Emerging Markets? by Brian Aitken, are available for $7.00 each from Publication Services, Box XS600, International Monetary Fund, Washington, DC 20431 U.S.A. Telephone: (202) 623-7201; fax (202) 623-7430; Internet:

David M. Cheney, Editor

Sara Kane • John Starrels

Senior Editors

Sheila Meehan

Assistant Editor

Sharon Metzger

Editorial Assistant

Lijun Li

Staff Assistant

Philip Torsani

Art Editor

In-Ok Yoon

Graphic Artist

The IMF Survey (ISSN 0047-083X) is published by the International Monetary Fund 23 times a year, in addition to an annual Supplement on the IMF, an annual Index, and other occasional supplements. Editions are also published in French and Spanish. Opinions and materials in the IMF Survey, including any legal aspects, do not necessarily reflect the official views of the IMF. Address editorial correspondence to Current Publications Division, Room IS9-1300, International Monetary Fund, Washington, DC 20431 U.S.A. Telephone: (202) 623-8585. The IMF Survey is mailed by first class mail in Canada, Mexico, and the United States, and by airspeed elsewhere. Private firms and individuals are charged an annual rate of US$79.00. Apply for subscriptions to Publication Services, Box XS600, IMF, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430. Cable: Interfund. Fax: (202) 623-7201. Internet:

IMF Survey: Volume 25 1996
Author: International Monetary Fund. External Relations Dept.