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. www.imf.org/external/pubs/ft/survey/so/home.aspx

Abstract

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. www.imf.org/external/pubs/ft/survey/so/home.aspx

Healthy Banks Are Vital for a Strong Economy

Banking crises have become the “issue du jour,” said IMF First Deputy Managing Director Stanley Fischer, moderator of a recent IMF-sponsored roundtable on experiences in dealing with banking crises. The number of countries experiencing significant banking problems has increased substantially in recent years—hitting industrial and developing countries alike—and the high costs and macroeconomic disruptions caused by banking crises have become a matter of increasing concern to the international financial community.

Covering the theoretical and the practical, roundtable participants—including IMF staff and senior officials from member country financial institutions—discussed both general and country-specific experiences. Although these experiences differed according to each country’s circumstances, participants generally agreed that a sound banking system was necessary to support effective macroeconomic policy; and that, in most cases, it was costly and counterproductive to keep unhealthy banks alive through artificial resuscitation.

Bank Soundness and Macroeconomic Policy

One of the most important conditions for avoiding serious banking crises is the pursuit of stable macroeconomic policies, according to Michael Mussa, Director of the IMF’s Research Department. Nonetheless, principles of sound banking and effective regulation and supervision are vital to limit the adverse impact of macroeconomic disturbances.

The fragility of banking systems also constrains the conduct of macroeconomic policy. Banking problems in the United States and Japan in the 1990s hampered the efforts of these countries to recover from recession. Similarly, during the European exchange rate mechanism crisis of 1992, the United Kingdom was constrained by problems in its banking system. Banking problems imposed costs and constraints on the macroeconomy and the conduct of macroeconomic policy in both industrial and many developing and emerging economies. One of the common themes underlying the cause of banking difficulties in many countries related to the “boom and bust” cycles, according to Mussa. Under boom conditions, banks often extended risky loans that turned sour when the bust occurred. An important aspect of sound regulation was to allow the discipline of the market to operate, to ensure that unsound banks fail and their managements are fired.

Role of Central Bank in a Banking Crisis

As the center of the financial system, the central bank faces both a short-term and a medium-term challenge in a financial crisis, according to Manuel Guitián, Director of the IMF’s Monetary and Exchange Affairs Department. In the short term, the central bank may need to act as a lender of last resort; in the medium term, it is a major player in the restructuring of the financial sector. In both of these roles, the central bank faces a dilemma: it must support the financial sector, but it must also fulfill its principal function of maintaining economic stability through a credible, responsible monetary policy.

Lender of Last Resort. Ideally, the short-term response of the central bank to a crisis is to provide relief only to solvent but illiquid banks to prevent them from engaging in “distress sales.” A major difficulty with this approach is that it is not always easy to distinguish between insolvency and illiquidity.

The lender-of-last-resort function involves net injections of liquidity into the economy and thus has a monetary impact that conflicts with the chief objective of monetary policy, which is to maintain stability and low inflation.

Bank Credit Procedures Are Key

The past decade has witnessed a string of banking crises, some of them associated with sharp swings in asset prices, severe bouts of exchange market volatility, shifts in the macroeconomic environment, and problems in key emerging markets. To prevent such crises in the future, much effort has gone into improving financial system regulation and supervision. Yet, according to Gerald Corrigan, former Chainman of the U.S. Federal Reserve Bank of New York and of the Basle Committee on Banking Supervision, strengthening regulatory and supervisory capability is only part of the solution. The essential requirement is the development of a culture of credit, including improvements in banks’ credit procedures and the institutional environment in which credit transactions take place.

A group of IMF staff recently had the opportunity to exchange views on banking system soundness and supervision informally with Corrigan at a seminar chaired by IMF First Deputy Managing Director Stanley Fischer. The IMF holds such seminars from time to time to provide staff with an opportunity to go “one-on-one” with leading experts on the key policy issues that arise in the IMF’s work with member countries.

Although banking crises might be triggered by a variety of circumstances, their common denominator, according to Corrigan, is poor quality assets, which are often difficult for even the best supervisory systems to detect. The problem often begins right at the loan application stage, when banks compile information about prospective borrowers. In industrial countries, much of the information declared by the borrower can be verified by credit bureaus, tax returns, and securities market prospectuses, and the borrower’s obligation to be truthful is backed by legal sanctions. This may not be the case in developing countries, where the mechanisms to verify information about borrowers are generally lacking. Moreover, the fact that some companies belong to industrial groups that are principal shareholders of the banks that lend to them makes the information problem in some developing countries even more acute.

The next stage—loan approval—is also important. The policies and procedures surrounding the credit review process must be flexible and adapt over time to changing circumstances. In the banking systems of many emerging economies, such flexible and adaptable policies and procedures are still in the early stages of development, incomplete information about the borrower combined with weak approval procedures can greatly increase the potential for problem loans down the road.

Loans need to be monitored, and Corrigan emphasized that monitoring procedures should go beyond simply verifying whether a loan is being serviced. He noted that monitoring systems in developing countries had improved a lot in recent years, but they often failed to catch potential problems because of incorrect or distorted information, or even too much (often irrelevant) information, about borrowers. Monitoring systems need to be forward looking—is the borrower or the industry likely to experience problems in the future? According to Corrigan, this key part of the credit cycle has often been ignored.

Finally, in cases of default, banks in many developing countries were handicapped by an uncertain legal framework for enforcing judgments against borrowers. The legal costs and time involved in collection added greatly to the cost of problem loans. Banks’ balance sheets could be further weakened by such dubious practices as capitalizing overdue interest and recording it as income.

In the face of these pitfalls in the credit process—often hidden to bank supervisors—what should governments do to make their banking systems more resistant to crises? Corrigan had a number of suggestions, including:

Better information systems. Governments in developing and transition countries should encourage the establishment of independent, private credit bureaus to gather reliable information on borrowers. In his experience, Corrigan had found that credit bureaus can make a difference in a relatively short time. For example, simply setting up a consistent set of information standards for granting a mortgage could have a measurable positive impact on that segment of the financial sector.

Reform the legal framework. Banks need to operate within a supportive legal environment for debt workouts to succeed. Corrigan advocated legal reforms to sweep away the institutional barriers to the orderly resolution of bad debts. This was an area where technical assistance and prodding from international financial institutions such as the IMF could be very helpful.

Last, but not least, strengthen bank regulation and supervision. In Corrigan’s view, accelerating the hiring and training of quality bank supervisors should be the highest priority for central banks in developing and transition countries. Loan examination is a “fine art” that requires education, training, and practical experience. Even with the most outstanding recruits, it takes time (at least two to three years) to recruit and train capable bank inspectors—something those jumping on the “stronger bank supervision bandwagon” tended to forget. (Nevertheless, the process can be accelerated through the “buddy system,” whereby trainees from developing and transition countries work side-by-side with seasoned bank examiners in industrial countries.) Corrigan also noted that countries often needed to introduce new, stronger regulatory frameworks to reinforce supervisory efforts.

Claire Liuksila

Editor, Finance & Development

Because the lender-of-last-resort function can have potentially risky consequences, the central bank should exercise it only in exceptional circumstances, Guitián said. Rather, the central bank should focus on prevention through the appropriate supervision of banks.

Restructuring the Financial Sector. In the medium-term task of restructuring the financial sector, the role of the central bank—as well as those of government and the private sector—must be defined, Guitián said. The central bank is necessarily a focal point, but it faces the dilemma of having to restructure the banking system without endangering its credibility in maintaining price stability. For this reason, Guitián concluded, its role should be strictly advisory, while bank restructuring should be financed by government and private sources.

Case Histories

Mexico. Ariel Buira Seira, Deputy Governor of the Bank of Mexico, said that the banking crisis had its origins in the sudden and drastic reduction in net foreign credits to the country. In dealing with the banking crisis, the Mexican authorities were guided by several principles:

• preventing the development of systemic risk;

• avoiding an undue expansion of net domestic credit by the central bank;

• resisting political pressures to bail out shareholders while protecting the interests of creditors and borrowers;

• minimizing the fiscal cost of policies adopted to overcome the crises; and

• interfering to the least possible extent with the normal functioning of the market.

The Mexican authorities adopted a number of measures to deal with the banking crisis. These included the creation of new programs to help commercial banks and debtors withstand shocks arising from external outflows and devaluation. These actions, said Buira Seira, had successfully mitigated the effects of the crisis.

Estonia. Vahur Kraft, Governor of the Bank of Estonia, noted that his country did not develop a modern banking system until the early 1990s, and the first Estonian currency was introduced in June 1992 under a currency board arrangement. At the end of 1992, more than one fourth of the banking system went bankrupt, mainly because of unfamiliarity with banking practices and, sometimes, incompetence on the part of bank managers.

In the wake of the crisis, many failed banks were allowed to close and some were restructured. The currency board arrangement, with its defined currency issue mechanism and fixed exchange rate serving as a nominal anchor, helped contain the effects of the crisis by giving credibility to the conduct of monetary policy. The stabilization effort pursued by the authorities during the banking crisis, which was supported by credible policies, also helped attract foreign financing. This gave the authorities breathing space to enact radical banking reform. In the last few years, Kraft said, the Estonian banking system had witnessed a gradual but considerable improvement in competence, sophistication, and credibility.

Zambia. The financial crisis that exploded in Zambia in the 1990s was internally generated by poor management and even recklessness in banking practices in some cases, according to Jacob Mwanza, Governor of the Bank of Zambia. During the second half of the 1980s, some banks had been created solely for the purpose of financing the operations of specific public enterprises. Although the Bank of Zambia was in charge of banking supervision, the Ministry of Finance had the authority to grant licenses to establish banks.

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

The Zambian authorities have acted decisively in the past few years to contain the banking crisis and correct past mistakes, according to Mwanza. In December 1994, Zambia enacted the Banking and Financial Services Act to enable the Bank of Zambia to close commercial banks and impose restrictions on their activities. The law also substantially raised minimum capital requirements necessary to establish banks. Zambia is also creating an effective supervisory department within the Bank of Zambia that will authorize the central bank to undertake on-site inspection of banks without prior warning.

Japan. According to Akira Nagashima, Deputy Governor for International Relations at the Bank of Japan, the banking crisis in Japan was closely related to the emergence and subsequent collapse of the so-called speculative bubble from the late 1980s to the early 1990s. During 1986-88, the yen appreciated sharply, and the monetary authorities followed an expansionary monetary policy to offset the dampening effects of the appreciation of the currency on the economy. Although the money supply and asset prices rose rapidly, there were no signs of rising inflation. Large unrealized capital gains prompted banks to extend credit, but they often lent to companies involved in risk-taking and speculation. In addition, said Nagashima, a widespread sense of euphoria prevailed; the country was “obsessed” with expectations of extremely high rates of return on investments.

When monetary conditions were tightened starting in 1989 and quantitative restrictions on real estate lending were imposed in 1990, the bubble burst and a banking crisis emerged. The authorities acted to mitigate the effects of the crisis by adopting several measures, including the use of central bank money. However, financing by the central bank was made available under strict conditions so as not to jeopardize the bank’s credibility.

The main lesson from the crisis, Nagashima said, was that it was best to act to prevent a bubble economy from emerging. Rules for disclosure and transparency were also important. Another lesson was that “forbearance policy”—banks will recover when the economy does—was not a good way to deal with troubled banks.

Roundtable

In a roundtable discussion, Nasser Saidi, Vice Governor of the Bank of Lebanon, remarked that it would be useful to discuss the role of financial markets in reducing the risk and potential for banking crises.

Jarle Bergo, Deputy Governor, Norges Bank, noted that the Norwegian authorities had dealt decisively with the banking crisis of 1991-93 through the creation of a special independent agency to address banking problems. This strategy had succeeded in avoiding excessive monetary creation.

Antonio Casas González, President of the Central Bank of Venezuela, noted that no single international monetary agency provided a safety net in case of a banking crisis. As the experience of Argentina had demonstrated, a currency board arrangement that provides an anchor for the exchange rate was insufficient to prevent a crisis. When a crisis occurs, the central bank has to intervene because no other agency can act as lender of last resort.

Stefan Ingves, Deputy Governor, Sveriges Riksbank, agreed with Nagashima about the importance of transparency and disclosure in financial crises. Experience has also shown that decisive action has to be taken early, he said, but there was also a need for political consensus.

Esko Ollila, a member of the Board of Governors, of the Bank of Finland, shared Mussa’s view that overall economic stability was the most important factor in mitigating the effects of a financial crisis. He noted the importance of financial policy reform (in addition to regulatory and supervisory reform) in dealing with banking crises.

Khorshed Alam, Governor of Bangladesh Bank, noted that when governments own banks, the emergence of a crisis would not be apparent, even though banks had nonperforming portfolios.

Bangladesh had experienced banking problems in the past, he said, but the authorities took effective measures to deal with the situation, including restructuring, financial liberalization, current account convertibility, and reform of the legal framework. However, the banking system was still weak and imposed a constraint on the conduct of monetary policy.

Krzysztof Kalicki, First Deputy Minister of the Polish Ministry of Finance, said that the Ministry of Finance had been the main player in overcoming the banking crisis in Poland. A number of conditions had been set for the restructuring of banks, including establishing different paths for individual banks and setting up transparent rules and regulations for restructuring operations. However, financial restructuring alone was not always enough to solve a banking crisis; managerial competence still played an important role in implementing sound banking practices.

Samir El-Khouri

IMF Institute

Chile Pursues Macro Stability While Boosting Social Spending Chile Invests in Human Capital

Chile’s economy has turned in a strong performance in the 1990s. In the context of prudent, market-oriented macroeconomic policies and far-reaching structural reforms, real GDP growth averaged 7 percent a year during 1990-94; inflation fell to less than 9 percent in 1994 from 27 percent in 1990, and public finances registered a continuous surplus. In 1995, real GDP picked up to 8½ percent, while inflation declined to 8.2 percent; public finances strengthened to a surplus of 2.8 percent of GDP, owing in part to higher copper prices. In 1996, real GDP growth has moderated from its unsustainable pace, abating concerns about overheating. Over the last five years, Chile’s external position has been bolstered and net international reserves of the central bank have increased to $14.7 billion at mid-1996 (equivalent to about ten months of imports of goods and nonfactor services). Despite the recent sharp decline in copper prices, Chile’s medium-term outlook remains favorable.

A commitment to ameliorate social conditions has complemented this broad-based economic progress. Social expenditure increased to 61 percent of total public expenditure in 1995 from 55 percent in 1990, with increases concentrated in education, health, and housing. Throughout this period, social expenditure represented 13 percent of GDP, while overall public expenditure declined to 20.9 percent of GDP in 1995 from 23.3 percent in 1990.

The government also has increased cash transfers to the poor, notably through targeted family allowances and minimum pensions. The authorities remain committed to maintaining a strong fiscal position. They have offset higher social expenditure with a combination of tax increases and cuts in other public spending.

As a result of these policies, the incidence of poverty has declined sharply, from 40 percent in 1990 to 28.5 percent in 1994. Illiteracy has been reduced to less than 5 percent, and primary education has become virtually universal.

Considerable progress has been recorded across a spectrum of social indicators, but the Chilean authorities acknowledge that much remains to be done. They are committed to further improving social equity through more efficient and better-targeted social spending. Their efforts continue to focus on human capital formation—notably, but not exclusively, in education—to enhance income opportunities for lower-income groups and strengthen the competitiveness of the economy.

Education Reform

The Chilean authorities have focused on education as the keystone of their efforts to implement structural reforms that will serve the country’s long-term development and social needs. In August 1996, the Chilean Congress approved a law that provides the basis for a sweeping reform of the country’s educational system.

In Chile’s highly decentralized educational system, public schools are managed by municipal authorities. Families may choose between these public schools and publicly certified private schools that receive transfers from the central government based on the number of children in attendance. Although enrollment is high and the average number of years of schooling is among the highest in the region, the quality of education—according to recent government surveys—is low with respect to what the authorities desire.

Beginning in 1990, Chile took steps to address the quality of education. Government initiatives raised education transfers, improved teacher salaries and training, and increased the availability of textbooks and other instructional material. Expenditures were targeted to boost the quality of education for low-income students, particularly in rural areas. As a result of these reforms, the share of education expenditures in total public spending rose to 14 percent in 1995 from 12 percent in 1990.

The cornerstone of Chile’s current ambitious educational initiative is a significant increase in school hours. Under the proposed reform, students in grades 3 through 12 would see their school day expanded to 5.7-6.3 hours from the current 4.5–5.5 hours. The reform would update curricula and improve the quality of teaching through increased training and better incentives for teachers.

The reform would also increase the education transfer paid to schools and the financing to construct additional classrooms for the 40 percent of the country’s schools that now operate classrooms in double shifts. The Chilean authorities anticipate implementing this reform over a six-year period, starting in 1997, at an estimated cost of $1.5 billion. Most of the program’s financing would be provided by an extension of the current 18 percent value-added tax, which had been mandated by law to drop to 17 percent beginning in 1998.

Chile’s reform of its educational system reflects the government’s efforts to maintain rapid growth while alleviating poverty and improving income distribution—the government’s main goals since 1990. Chile’s experience in building a strong macroeconomic basis and pursuing social goals rooted in a well-targeted and fiscally responsible use of resources has been remarkable. Still to be answered, however, is the extent to which Chile’s experience is transferable.

Pacific Division,

IMF Western Hemisphere Department

France Is Donor to IMF Technical Assistance Fund

France recently signed on as a financial supporter of IMF technical assistance activities, joining Japan, Australia, and Switzerland. To accommodate bilateral donors wishing to extend such financial support, the IMF in April 1995 established the Framework Administered Account for Technical Assistance Activities. Under the Framework Account, subaccounts are established with individual country donors or for specific purposes. The French offer of support for IMF technical assistance now brings the number of subaccounts to five:

• Japan Advanced Scholarship Program;

• Rwanda: Macroeconomic Management Capacity;

• Australia: IMF Scholarship Program for Asia;

• Switzerland Technical Assistance; and

French Technical Assistance.

The French subaccount will be used to cofinance the costs of training and technical assistance in economic fields, consistent with the IMF’s purposes, for nationals of 32 African and 4 Caribbean countries. The training is organized by the IMF Institute, which provides training for senior and mid-level officials of member countries, at IMF headquarters, the Joint Vienna Institute, and national and regional centers. The first two activities to be cofinanced from the French subaccount are a December 1996 workshop on bank restructuring and the development of financial markets, to be held in Gabon, and an April 1997 seminar on ways to prevent corruption in tax collection and public cash management.

Kuwait: Structural Reform Follows Reconstruction

Soon after the 1990-91 Gulf crisis caused by the Iraqi invasion of Kuwait, the Kuwaiti government successfully reconstructed and rehabilitated its economy. Since then, the government has turned its attention to addressing structural weaknesses in the economy: vulnerability of the budget, growing tensions in the labor market, and impediments in the financial system. A recent internal analysis by a staff team from the IMF’s Middle Eastern Department examines Kuwait’s progress with fiscal consolidation and structural reform.

Bridging Past and Future

Kuwait is one of the richest countries in the world, with a per capita GDP of about $19,000 a year, higher than that of Finland, the United Kingdom, and Australia (see table, page 350). It has large oil reserves and possesses considerable foreign assets. Prior to the Iraqi invasion in 1991, Kuwait enjoyed economic growth, low inflation, and a steady increase in foreign asset holdings.

The Iraqi invasion inflicted considerable damage on Kuwait. It caused major physical damage to oil facilities and resulted in large budgetary and balance of payments deficits. The occupation also disrupted the domestic financial market, halted foreign trade, and paralyzed the labor market. More than 60 percent of Kuwaiti oil wells, the lifeline of the economy, were set on fire. While estimates of the total damage to oil facilities vary, the cost is likely to have exceeded $10 billion. Production of goods and services came to a virtual standstill during the occupation, with estimated GDP amounting to only 10-20 percent of its preinvasion level.

Case for Fiscal Consolidation

With investment income declining because of the drawdown in foreign assets to finance liberalization and reconstruction, the Kuwaiti fiscal system lost its revenue stabilizer. This has heightened the country’s vulnerability to unfavorable external developments.

Historically, Kuwait had recorded fiscal surpluses and had built up official assets so that future generations would benefit from the proceeds of the nonrenewable oil reserves extracted in the current period. It has only recently—since the Iraqi occupation—recorded budget deficits, reflecting initially the high spending associated with reconstruction, together with lower investment income, as a result of the drawdown of official foreign assets. By 1994/95 (the fiscal year runs from July through June), Kuwait’s budget deficit was reduced to less than 12 percent of GDP, from about 97 percent at the peak of the Gulf war and 22 percent during reconstruction in 1992–93, owing to the restoration of oil exports and the winding down of many post-liberation exceptional outlays,

Despite this favorable trend in the fiscal balance, the structure of the Kuwaiti budget has remained weak, with heavy dependence on oil revenues and large outlays related to the costs and subsidies associated with the cradle-to-grave social welfare system. With oil receipts accounting for 80 percent of fiscal revenues and a relatively inflexible expediture structure, the economy remains highly sensitive to adverse developments in international oil markets. This vulnerability is accentuated by the significant fluctuations in Kuwait’s terms of trade—at 1995 production levels, a $1 change in the per barrel price translates, other things being equal, into a $0.7 billion change in annual export receipts.

Photo Credits: Denio Zara and Padraic Hughes for the IMF, pages 345 and 352; Michael Dwyer for Stock Boston, page 351.

Kuwait and the World

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Data: IMF and the World Bank

The authorities’ recently formulated five-year plan recognizes the need to reduce the fiscal deficit concurrent with strengthening the structure of the budget, and it targets budget balance by 1999/2000. Critical to achieving this goal will be the Kuwaiti government’s commitment to implementing the measures necessary Co reduce the dependency on oil revenues by broadening the tax and nontax revenue bases and restrictions on current spending.

Key measures proposed by the authorities include increases in customs duties from their current low levels; restructuring the corporate income tax; higher charges for goods and services provided by the state; and containment of public expenditure. Fiscal consolidation—by definition, a driving force in a small open economy with a fixed exchange rate—is expected to stimulate all other sectors of the economy, especially the labor market.

Labor Market Constraints

Labor market problems range from the need to find sustainable employment opportunities for the growing number of nationals joining the labor force, to larger foreign exchange outflows associated with a more transient expatriate population—which constitutes more than half of Kuwait’s total population.

Kuwait’s labor market remains highly segmented, with limited mobility. The public sector employs more than 90 percent of the Kuwaiti labor force at salary and benefit packages that, on average, are significantly more generous than those offered by the private sector, which depends heavily on expatriate workers. There is a strong behavioral relationship between fiscal spending and private sector activity in Kuwait, with an increase or decrease in budget expenditures translating directly into a gain or loss of jobs. The IMF analysis suggests that the needed fiscal retrenchment, other things being equal, will initially have some contractionary impacts: directly by limiting the government’s role as employer of first and last resort, and indirectly through the contractionary influence on private sector non-oil activity. Thus, fiscal consolidation measures must be designed carefully to minimize their impact on the private sector. Determined efforts to intensity-structural reforms and enhance private sector investment will mitigate this effect and establish the basis for sustainable private sector growth.

While many approaches are available to the authorities to meet the labor market challenge, two are particularly relevant:

• Improving the functioning of the labor market. In addition to more buoyant non-oil activities, steps are needed to remove the bias in favor of public sector employment, including containing the government wage bill and equalizing benefits between the public and private sectors.

• Enhancing the ability of the private sector to provide sustainable employment opportunities. Particular emphasis is being placed on deregulation, liberalization, and privatization. A transfer of responsibilities from the public to the private sector is being stimulated, as well as a reduction in the barriers to private sector investment.

Striving for Financial Discipline

The Kuwaiti authorities also face the challenge of reducing moral hazard risk, thereby restoring the integrity of the financial markets and ameliorating intermediation functions.

Kuwait’s financial sector has been subject to two major shocks in recent years: the collapse of the unofficial stock exchange in 1982, which resulted in bad debts on a wide scale; and the Iraqi invasion, which destroyed physical assets and rendered many loans held by the Kuwaiti financial sector prior to the invasion uncollectible. Following liberation, the authorities moved quickly to restore normal banking operations. Deposits were restored to their pre-invasion levels. A currency reform also went smoothly, and the authorities managed to restore and maintain the pre-invasion exchange rate arrangement. The basic structure and institutional features of Kuwait’s financial system, however, have not changed much over the past 20 years.

Having overcome the risk of large-scale deposit withdrawals, the government then moved to address the problem of nonperforming loans, most recently through the Debt Collection Program. The continued successful implementation of this program will determine Kuwait’s ability not only to resolve bad loan problems and fully restore payment discipline in the financial sector but, more important, to improve financial intermediation. The Kuwaiti financial system could then return to the strong position needed to support the reforms aimed at enhancing the private sector’s role in production, investment, and employment generation.

The central bank has made significant progress in recent years in developing policy instruments by relying more on indirect means of monetary control, moving gradually toward a more liberal regime, and bolstering its supervisory functions across a broad front. The central bank has also taken steps to strengthen capital adequacy standards, accounting procedures, and on-and off-site supervision. Progress in these areas has helped restore confidence in the domestic financial system. For example, interest rate differentials between Kuwaiti dinar-and U.S. dollar-denominated financial instruments have narrowed sharply. Deposit holdings—in both domestic and foreign currency—have continued to increase, reinforced in 1995 by indications of capital repatriation by residents. Finally, the stock market has registered significant increases in trading volume and value in 1995–96.

Abundantly endowed with an important resource and well connected to the international financial markets, Kuwait has moved gradually toward further liberalization of its economy, while at the same time consistently working to generate wealth and savings for future generations.

Alexei Kireyev

From the Executive Board

Lesotho: Stand-By

The IMF approved a 12-month standby credit for Lesotho equivalent to SDR 7 million (about $10 million) to support the government’s 1996/97 economic program.

Since 1992/93, Lesotho has achieved strong GNP growth while reducing the external current account deficit from 3.4 percent of GNP in 1992/93 to 2.0 percent in 1995/96. In the process, it has expanded exports, diversified production, increased savings, and accumulated substantial foreign exchange reserves. Structurally, Lesotho initiated a broad program by starting to dismantle inefficient agricultural regulations and reforming taxation, public expenditure, and the civil service. However, these structural reforms must be accelerated to deal effectively with likely future shocks stemming from the risk of loss of manufacturing competitiveness and from the prospective decline of miners’ remittances from South Africa, as well as reducing unemployment and poverty.

The 1996/97 Program

In order to support Lesotho’s continued growth, external adjustment, and structural reform, the authorities’ strategy will utilize the fiscal surplus to accumulate international reserves while promoting further investment in the manufacturing sector in order to reduce unemployment and poverty. Consistent with this strategy, the program for 1996/97 aims at achieving a real GNP growth rate of 10.2 percent; limiting the increase in the consumer price index to no more than 10 percent; and reducing the external current account deficit to 1.8 percent of GNP from 2 percent in 1995/96.

To these ends, the program provides for a fiscal surplus of 1.3 percent of GNP in 1996/97 by improving the sales tax yield and by increasing customs and noncustoms revenues and grants. Recurrent expenditure will be held at 20.3 percent of GNP through restraining government wages, in order to keep the wage bill below 10 percent of GNP, while capital expenditure will be little changed at about 11 percent of GNP. Within the context of a restrained credit policy, provision is made for a decline in total domestic credit while allowing for a reasonable expansion in lending to the parastatal and private sectors.

Ruggiero Previews WTO Ministerial Conference

The first ministerial conference of the World Trade Organization (WTO), to be held in Singapore in December, will be an important part of the economic and political process of trade liberalization, with substantive decisions to be made, said Renato Ruggiero, Director-General of the WTO at a September 30 seminar sponsored by the Washington-based Institute for International Economics (IIE). While it was too soon to predict the outcome of the ministerial conference, WTO members were “moving toward consensus” on many key issues. Ruggiero termed a “major achievement” the satisfactory operation of the dispute settlement procedures, which had gained the confidence of both industrial and developing country members. He pointed to the WTO’s 123 members—with more than 30 countries engaged in the accession process—to underscore the institution’s rapid progress toward universal membership.

The Singapore conference, Ruggiero noted, could be particularly useful in giving impetus to new WTO efforts in several areas: the accession process; the relationship between trade and the environment, on which Ruggiero was optimistic; and the relationship between trade and labor standards. On the latter, Ruggiero outlined the elements of his compromise proposal, which rests on four principles: all WTO members should respect the International Declaration on Human Rights; the International Labor Organization has the main responsibility for setting labor standards; WTO efforts should not penalize low-wage countries; and trade restrictions are not the answer to the problem of low labor standards. Also important was the need to conclude an information technology agreement and strengthen efforts to complete the telecommunications and financial services negotiations. Resolving the latter two issues would “put the WTO on the map,” said Ruggiero.

The Director-General stressed that the Singapore ministerial conference must send a message of the unity and vitality of the multilateral trading system. A universal and rule-based trading system must be clearly endorsed, and the political dimension of the WTO improved. Globalization must be seen as an opportunity, rather than a challenge, and regionalism and multilateralism must be converging trends, Ruggiero concluded.

Preceding Ruggiero, Jeffrey Schott summarized his new IIE study, WTO 2000: Setting the Course for World Trade. At the Singapore conference, Schott said, WTO members need to adopt specific initiatives to demonstrate their commitment to expanding global trade and investment in goods and services. He recommended that they commit to rapidly accelerating implementation of Uruguay Round trade reforms; eliminate all tariffs of 2 percent or less (nuisance tariffs); and launch new negotiations on investment by the end of 1997 and immediately establish a working group to develop the terms of reference for those talks.

David Cheney

Editor, IMF Survey

Structural Reforms

The program envisages major structural reforms to achieve sustained economic growth. The authorities will deregulate agricultural markets, take measures to promote further expansion in manufacturing, and move decisively to reform the operations of the principal state-owned public utilities. The government also plans to take decisive steps toward the privatization of several large enterprises. In addition, it will improve the management of public investment, implement a value-added tax, and undertake necessary reforms to ensure that the judiciary disposes promptly of commercial court cases and that courts’ judgments are effectively enforced.

Lesotho: Selected Economic Indicators

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Data: Lesotho authorities and IMF staff estimates

Estimates.

Program.

Social Issues

The government’s strategy for poverty reduction under the program contains efforts to sharpen priorities in education and health and to increase the efficiency of the social safety net through administrative improvements. Spending on education will increase in real terms and will focus on improving primary and secondary education. Support for health care will also be increased, emphasizing primary care and the prevention of serious diseases.

The Challenge Ahead

Miners’ remittances, which presently account for one-fourth of GNP, may decline significantly as a result of retrenchment in South Africa and potential emigration to the latter country of many Basotho miners and their families who have been granted permanent resident status in South Africa. Domestic wage pressures, which partially reflect the close integration of Lesotho’s labor markets with those in South Africa, threaten to erode competitiveness and impede the reduction of unemployment. This underscores the need for measures to increase growth, improve the functioning of labor markets and the financial sector, and otherwise increase economic efficiency.

Lesotho joined the IMF on July 25, 1968. Its quota is SDR 23.9 million (about $35 million), and its outstanding use of IMF credit currently totals SDR 24 million (about $35 million).

Press Release No. 96/48, September 24

Egypt: Stand-By

The IMF approved a 24-month stand-by credit for Egypt equivalent to SDR 271.4 million (about $391 million) in support of the government’s economic and financial reform program. In view of Egypt’s present strong international reserve position, the government does not intend to draw on the stand-by credit.

Since 1991, Egypt has successfully implemented wide-ranging macroeconomic stabilization and structural reform measures supported by two successive IMF credits. Over the period, progress was made in strengthening public finances and creating a more decentralized, market-oriented and open economy. Real GDP growth accelerated to over 4 percent in 1995/96 from virtual stagnation in 1991/92, while the rate of inflation declined to 7 percent from over 21 percent. The overall balance of payments remained in surplus, leading to a substantial accumulation of net international reserves (reserves are currently equivalent to about 17 months of imports). With limited external borrowing and further debt relief from the Paris Club, the ratio of external debt to GDP fell to 47 percent in mid-1996 from about 75 percent in 1991/92, and the debt-service ratio declined to about 11 percent of current account receipts (excluding official transfers) from 14 percent in 1991/92. Nevertheless, performance under the three-year economic program supported by the IMF under the 1993 credit, which expired last month, fell short of Egypt’s considerable potential, particularly with regard to structural reforms.

Medium-Term Strategy and 1996-98 Program

The government sees the principal challenge for the medium term to be that of increasing economic growth so as to create employment opportunities for a rapidly growing population and raise living standards. To this end, the two-year economic program, which is set in a medium-term framework, focuses on consolidating the gains of macroeconomic stabilization and broadening and intensifying the structural reform agenda through privatization, deregulation, trade liberalization, and fiscal and financial sector reform.

Egypt: Selected Economic Indicators

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Data: Egyptian authorities and IMF staff estimates

Preliminary.

Program.

For the period 1996-98, the program aims at achieving a further increase in real GDP growth to about 5 percent in 1997/98, a further decrease in inflation to about 6 percent, and maintenance of a viable external position. The external current account is projected to shift from approximate balance in 1995/96 to a deficit of about 1 percent of GDP in each of the program years, reflecting the anticipated strong growth of imports driven by the recovery and higher investment. The increase in the growth rate is expected to create some 400,000 new jobs a year, which will help bring down the rate of unemployment and raise living standards. Underpinning the strengthened economic performance is a rise of about 2.5 percentage points in investment and savings relative to GDP over the program period.

To achieve these objectives, the overall budget deficit for 1996/97 will be reduced to 1.1 percent of GDP, excluding privatization receipts and any further debt relief. Other demand management policy elements will continue to be restrained, consistent with a further reduction in inflation and maintenance of a sound external position.

Structural Reforms

The program incorporates a number of structural reforms designed to foster the expansion of the private sector in order to promote investment, growth, and employment. A central goal of the program is to bring about a fundamental change in the ownership structure of the Egyptian economy, where public enterprises account for as much as one-third of Egypt’s manufacturing sector, half of investment expenditure, and about 15 percent of total employment. To this end, the program already under way envisages significant divestiture of nonfinancial public sector enterprises over the next two years. Other key structural reforms to be implemented over the medium term include further liberalization of Egypt’s international trade system, including further tariff reductions and elimination of quantitative restrictions; fiscal revenue reforms, including the transformation of the general sales tax into a value-added tax (VAT); rationalization of the income tax to make it simpler, broader based, and more transparent and equitable; a well-articulated medium-term program for improving the civil service; and an acceleration of financial sector reform, including privatization of banks and insurance companies, and a further strengthening of banking supervision. In addition, the government has initiated a series of administrative reforms aimed at reducing bureaucracy and red tape, including preparation of a unified investment law aimed at simplifying and rationalizing investment regulations.

Addressing Social Needs

The government is committed to improving Egypt’s health and education systems by increasing the number of qualified personnel such as nurses and teachers. This need will be met within the framework of a comprehensive civil service reform program aimed at the elimination of bureaucratic impediments to economic activity, improving the efficiency of government services, and building a cadre of well-paid and efficient civil servants. The authorities are further strengthening the social safety net while improving its targeting. Foreign donors are also increasing their support of the Social Fund for Development, which will facilitate increased assistance to displaced workers through compensation pay, retraining, and redeployment.

The Challenge Ahead

The present juncture offers a propitious point of departure for a reinvigorated economic reform program. The experience of the past few years attests to the benefits of economic reform. In addition, new challenges and opportunities are presented by recent international developments. Egypt needs to continue its structural reforms if it is to meet those challenges and exploit its considerable potential.

Egypt, a founding member of the IMF, signed the Articles of Agreement on December 27, 1945; its quota is SDR 678.4 million (about $976 million); and its outstanding use of IMF credit currently totals SDR 16.4 million (about $24 million).

Press Release No. 96/50, October 11

Ethiopia: ESAF

The IMF approved a new three-year loan under the enhanced structural adjustment facility (ESAF) for Ethiopia totaling the equivalent of SDR 88.5 million (about $127 million) to support the government’s medium-term economic and reform program for 1996-99. The first annual ESAF loan, in an amount equivalent to SDR 29.5 million (about $42 million), will be disbursed in two equal installments, the first of which is available immediately.

The transitional government of Ethiopia implemented an economic reform program in mid-1992, supported by a three-year loan under the IMF’s structural adjustment facility (SAF), designed to stabilize the economy and replace the previous system of central control and planning with a market-based system to create a favorable environment for renewed growth. In 1995/96, Ethiopia built upon the progress it had achieved under the program, especially by maintaining a prudent fiscal policy stance and exerting more effective monetary restraint while making additional advances in external liberalization. As a result, the country experienced economic growth of 7.7 percent, accompanied by a sharp deceleration in the rate of inflation to 1.2 percent and a further strengthening of the foreign exchange position to the equivalent of eight months of imports. It achieved this growth in spite of lower world market coffee prices that affected its terms of trade, resulting in a widening of the current account deficit to 9.6 percent of GDP, from 5.3 percent in 1994/95, as receipts from exports tapered off, while imports continued to grow strongly.

Ethiopia: Selected Economic Indicators

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Data; Ethiopian authorities and IMF staff estimates

Estimate.

Program.

Medium-Term Strategy and 1996/97 Program

Under Ethiopia’s medium-term strategy, the main macroeconomic objectives of the 1996-99 program, supported by the ESAF loan, are to achieve 6 percent growth in real GDP; limit the rate of inflation to 2 percent; contain the external current account deficit at about 9.2 percent of GDP; and maintain gross official foreign reserves at the equivalent of 7.5 months of imports.

The program aims to sustain economic growth with price stability through increased domestic savings and investment and a further substantial liberalization of the exchange and trade system. A rigorous fiscal policy stance is premised on the continued broadening of the tax base and strengthening of tax administration, as well as restraint in expenditures, including the phasing out of fertilizer subsidies and compression of the wage bill. The program includes appropriately tight monetary targets, which will require a move toward market-determined interest rates, particularly through more aggressive government sales of treasury bills to the nonbank public. In the external area, the program includes a number of actions, including an initial reduction in the export proceeds surrender requirement and the introduction of foreign exchange bureaus within the banking system, as well as near-and medium-term moves to lower tariff rates.

Within this medium-term strategy, the program for 1996/97 aims at real GDP growth of 6 percent, to limit the inflation rate to 1.2 percent, to contain the external current account deficit at about 10.5 percent of GDP, and to maintain gross official foreign reserves at the equivalent of eight months of imports.

Structural Reform Policies

In the area of structural reforms, Ethiopia has begun easing restrictions on foreign investment, adopting more realistic prices for the few commodities still subject to controls, and stepping up the market-based allocation of land. Privatization of public enterprises is being accelerated, and those enterprises remaining under government control will be operated on a strictly commercial basis. Revisions of the investment code have recently been enacted to permit private domestic investment in the telephone system and to allow joint ventures between foreign and domestic partners in selected activities, including large-scale engineering and metallurgical industries, and pharmaceutical and fertilizer production. The public auctioning of urban land leases is to be accelerated to support increased private investment, while the agricultural sector will be improved through the overhaul of extension and research services, the liberalization of input marketing, and the privatization of state farms.

Addressing Social Needs

Public investment will continue to emphasize urgently required physical and social infrastructure. In particular, the government will continue to redirect investment toward roads, energy, water supply, primary education, and basic health care. Budget shares for primary education and basic health services are to be increased, and health care financing will be improved. To enhance the status of women, the government plans to revise laws and regulations to guarantee equal access by women to resources, property, and business activities. With respect to population, education will be promoted with a view to reducing the fertility rate.

The Challenge Ahead

Ethiopia will require strong adjustment efforts in the years to come. To achieve debt sustainability, Ethiopia will also need to rely on exceptional financing and foreign direct investment. The program aims to maintain gross official foreign reserves at a level to provide a cushion for servicing external debt, and to withstand unforeseen terms of trade shocks or droughts.

Ethiopia joined the IMF on December 27, 1945, and its quota is SDR 98.3 million (about $141 million). Ethiopia’s outstanding use of IMF credit currently totals SDR 49.4 million (about $71 million).

Press Release No. 96/51, October 11

Chad: ESAF

The IMF approved a second annual loan for Chad under the enhanced structural adjustment facility (ESAF) equivalent to SDR 16.5 million (about $24 million), in support of the government’s 1996/97 macroeconomic and structural adjustment program. The loan will be made in two equal installments, the first of which will be available shortly. The three-year ESAF credit, for the equivalent of SDR 49.6 million (about $71 million) was approved on September 1, 1995 (see Press Release No. 95/44, IMF Survey, September 14, 1995).

Since mid-1994, Chad has been resolutely committed to a program of structural reform aimed at correcting internal and external imbalances and accelerating the pace of economic growth. The government has shown determination in carrying out these policies—especially the 1995/96 economic program supported by the ESAF—despite a climate of political uncertainty created by the first multiparty elections since independence held in the first half of 1996. The authorities’ efforts have been rewarded by a rebound in economic activity. Among the other achievements during the first year of the ESAF-supported program was a satisfactory fiscal performance and, on the structural side, progress in privatization.

Chad: Selected Economic Indicators

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Data: Chadian authorities and IMF staff estimates

Program.

Projected.

Medium-Term Objectives and 1996/97 Program

Chad’s macroeconomic objectives for the period 1996-99 include achieving average real GDP growth of more than 5.5 percent a year; lowering the rate of inflation from the average of 10 percent projected for 1996 to less than 3.5 percent by 1999; and reducing the external current account deficit (excluding official transfers) from the 17 percent of GDP projected for 1996 to just less than 13 percent in 1999.

Consistent with the medium-term strategy, the 1996/97 economic program aims at economic growth of 6 percent in 1996 and 5 percent in 1997, with inflation declining from an average of 10 percent in 1996 to 4 percent in 1997. The external current account deficit, after widening to 17 percent of GDP in 1996, is expected to narrow to 15.7 percent in 1997.

To these ends, the 1996/97 program calls for continued consolidation of the government’s finances, with the aim of reducing the overall fiscal deficit to 12.1 percent of GDP in 1997 from 14 percent in 1996. On the revenue side, efforts will focus on the reorganization of the tax directorate and on further improvements in customs efficiency, while on the expenditure side, overall spending, including the wage bill, will be strictly limited.

Chad’s monetary policy will continue to be formulated at the regional level in close consultation with its partners in the regional Central Bank of Central African States. Among other things, the central bank will keep a prudent credit stance to prevent the resurgence of excess demand pressures while consolidating foreign exchange reserves at a regional level.

Structural Reforms

Structural policies under the program will be driven by the desire to promote the recovery and development of the private sector. Building on the experience gained from the 1995/96 privatization program, the government is now in a position to undertake the reform of Chad’s largest state-owned enterprises. Studies on the modalities of privatization, including action plans, will be finalized for the cotton company (Cotonchad), the sugar company (Sonasut), and the electricity and water company (Stee). The post and telecommunications companies will be restructured in anticipation of the privatization of telecommunications activities.

Social Issues

Chad is among the poorest countries in terms of basic social indicators. In undertaking economic and structural reform, the government recognizes that the most powerful instrument for poverty alleviation is economic growth that increases employment and raises income levels. Where the reform program involves significant hardship, measures will be taken to soften the impact on the most vulnerable groups in society.

The Challenge Ahead

Chad’s demonstrated determination to continue to strengthen economic and financial management and to undertake critical structural reform is the key to success of the program. Adequate assurances exist that the necessary exceptional external financing (other than that of the IMF and the World Bank) will be available for 1996/97 to meet financing gaps.

Chad joined the IMF on July 10, 1963. Its quota is SDR 41.3 million (about $59 million), and its outstanding use of IMF credit currently totals SDR 39 million (about $56 million).

Press Release No. 96/52, October 16

Recent IMF Publications

Working Papers ($7.00)

96/102: Erosion of Expenditure Management System: An Unintended Consequence of Donor Approaches. A. Premchand

96/103: Improving the Efficiency of the U.S. CPI, Paul A. Armknecht

96/104: Noise Traders and Herding Behavior, Lee S. Redding

96/105: Investment in Inflationary Economies, Eduardo Levy Yeyati

96/106: A Robust and Efficient Method for Solving Nonlinear Rational Expectations Models, Michel Juillard and Douglas Laxton

96/107: Domestic, Foreign, or Common Shocks?, Stefania Fabrizio and J. Humberto Lopez

96/108: Monetary Policy in Central and Eastern Europe: Lessons After Half a Decade of Transition, David K. H. Begg

96/109: Inflation, Nominal Interest Rates, and the Variability of Output, Bankim Chadha and Daniel Tsiddon

96/110: Current Account Sustainability: Selected East Asian and Latin American Experiences, Gian Maria Milesi-Ferretti and Assaf Razin

World Economic and Financial Surveys

International Capital Markets: Developments, Prospects, and Key Policy Issues ($20.00; academic rate: $12.00)

World Economic Outlook, October 1996 ($35.00; academic rate: $24.00)

Books

Annual Report of the Executive Board, 1996 (free)

Bank Soundness and Macroeconomic Policy, Carl-Johan Lindgren and others ($23.50)

The Future of the SDR in Light of Changes in the International Monetary System, edited by Michael Mussa and other; ($27.50)

Occasional Papers ($15.00; academic rate: $12.00)

No. 141: Monetary and Exchange System Reforms in China: An Experiment in Gradualism, Hassanali Mehran and others

Economic Issues (free) NEW

No. 1: Growth in East Asia: What We can and Cannot Infer, Michael Sard

No. 2: Does the Exchange Rate Regime Matter for Inflation and Growth?, Atish R. Ghosh and others

No. 3: Confronting budget Deficits

Publications are available from Publication Services, Box XS600, IMF, Washington, DC 20431 U.S.A. Telephone: (202) 623-7430; fax: (202) 623-7201; Internet: publications@imf.org For information about the IMF on the Internet—including the IMF Survey’s annual Supplement on the IMF and daily SDR exchange rates of 45 currencies—please visit the IMF’s new web site (http://www.imf.org).

Budget Procedures and Institutions Influence Budget Outcomes

Reviewing current theoretical work and recent empirical data from industrial and Latin American countries, Alberto Alesina and Roberto Perotti, in an IMF Working Paper entitled Budget Deficits and Budget Institutions, conclude that the variety of ways in which countries prepare their budgets, navigate the legislative approval process, and implement these budgets helps determine the degree of fiscal discipline exercised. Drawing from this survey of current research and data, the authors recommend an appropriate role for hierarchical procedures in the budget process, the creation of independent budget institutions, and the development of rules and practices that ensure accuracy and transparency in public budgets.

Over the past thirty years, public debt-to-GNP ratios have grown markedly in many industrial countries. In some instances, debt ratios have even exceeded 100 percent. Paralleling this sharp climb in debt ratios has been a dramatic change in the factors responsible for the growth of public debt. While twenty years ago the purchase of goods and services would have been the main such factor, transfers now play the major role in public deficits and debt. Transfers, which have proven notoriously difficult to cut because of their broad popularity with the electorate, have immeasurably complicated the process of fiscal adjustment.

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Budgetary Institutions

Budgetary institutions encompass all the rules and regulations governing the drafting, approval, and implementation of the budget. Typically, a constellation of social, political, and historical factors have shaped these budget institutions over time, but the growth and persistence of deficits in recent decades have led countries to re-examine what could be done to promote more effective fiscal discipline.

A number of countries have weighed the merits of a balanced budget law, but Alesina and Perotti contend that this legal fix is neither necessary nor sufficient to achieve fiscal discipline. They cite both Keynesian objections (the straightjacket imposed on policymakers who wish to pursue countercyclical measures) and tax-smoothing goals (a balanced budget would constrain the appropriate use of budget deficits and surpluses over the cycle, which constitutes an optimal tax-smoothing policy). Appropriate procedures, argue the authors, need not sacrifice flexibility for fiscal discipline.

The key is developing appropriate budget procedures and creating greater budget transparency, according to the authors. They identify two crucial elements: appropriate voting procedures in the formulation and approval of the budget and enhanced transparency to reduce the opportunities for “creative budgeting.”

Voting Procedures. A vital question in any examination of budget institutions is who wields power (and when) in the budget process. Two models exist: a hierarchical one in which key ministers exercise considerable power, and a collegial model in which power is more equally dispersed. More hierarchical budget institutions accord the prime minister or finance minister pre-eminence vis-à-vis other spending ministers. The natural constituencies for the spending ministries tend to be groups or industries that will benefit from spending, while the finance ministry’s constituency is, at least in theory, the “average” taxpayer. Drawing on both theoretical literature and empirical evidence, Alesina and Perotti conclude that any procedural arrangement that increases the relative power of the finance minister is likely to increase fiscal discipline.

France and the United Kingdom provide the clearest examples of hierarchical arrangements. Neither of these countries has a debt problem, the authors underscore, despite a very large public sector in France and a relatively low rate of economic growth over the past two decades in the United Kingdom. By contrast, countries in which the treasury ministry has not been accorded special status figure prominently among the industrial countries with the highest debt-to-GNP ratios (Ireland, Italy, and Belgium) as well as among those with rapidly rising debt ratios.

Hierarchical and collegial models also figure in the budget approval process. Typically, say Alesina and Perotti, legislators in both parliamentary and U.S.-type democracies are viewed as the “big spenders.” Limiting the types of amendments that can be offered at the legislative stage is equated with greater fiscal responsibility. An attendant aspect is the seriousness of a rejection of a budget proposal. In some systems, such a rejection simply triggers a new budget proposal; in others, it can lead to the fall of the government. In certain situations, the higher risk attached to passage of the budget imposes a greater sense of responsibility on both the executive and legislative branches.

The rules governing the legislative debate of the budget are similarly important. A “closed rule” sharply limits the capacity of the legislature to amend the executive’s proposal, while an “open rule” affords substantial opportunity to amend it. Closed rules strengthen the hand of the executive. Comparative empirical evidence suggests that France possesses the most authoritarian approval procedures, while collegial procedures characterize Italy, Greece, and Denmark.

Ultimately, both theoretical research and practical country experience suggest that the more hierarchical institutions promote fiscal restraint and are more likely to avoid large and persistent deficits and to implement fiscal adjustments more promptly. But they do so at a cost, the authors say, since hierarchical institutions customarily generate budgets that explicitly favor majority interests.

Optimally, both extremes should be avoided. An open rule, for example, can be designed to accommodate amendments that do not increase the size of the budget deficit or spending. Or a mix of rules can include a closed rule for the size of the budget, and an open rule for amendments to the budget’s composition. Thus, the executive’s hand could be strengthened to pursue fiscal adjustment, while collegiality is preserved in purely allocative matters.

Transparency. Industrial country budgets are notably complex, but not always out of necessity. Complexity may offer its own advantages, observe Alesina and Perotti, affording opportunities for creative budgeting and allowing governments to more easily hide liabilities by shifting them to future budgets or by using off-budget funding sources. Governments have a variety of “tricks” at their disposal, including:

• Overestimating the expected growth of the economy, so that tax revenues are overestimated and interest rates and outlays are underestimated. “Bad luck” is then blamed for the “unexpected” additional deficit at year’s end.

• Overoptimistic forecasts that inflate the revenue potential of certain new policies, notably proposed tax increases.

Industrial country budgets are notably complex, but not always out of necessity.

• Creative budgeting that permits various items to be kept off the national budget.

• Strategic use of budget projections, particularly manipulation of the key “baseline.” By inflating the base-fine, politicians can create the illusion of fiscal conservatism without real costs to their constituencies. This illusion cannot be sustained indefinitely, but it can confuse the electorate and delay a realistic appreciation of the actual state of public finances.

• Strategic use of multiyear budgeting. A three-year adjustment plan in which all the hard choices take place in year three in effect “buys time.” Subsequent multiyear budgets, of course, provide the opportunity for further postponement.

Industrial country budgets are notably complex, but not always out of necessity.

Alesina and Perotti note that two high-debt industrial countries, Italy and Ireland, have the least transparent budgets. This observation is bolstered by evidence from Latin America, where more hierarchical and transparent procedures were associated with lower primary deficits during 1980-93.

While the growing body of literature on budget institutions and procedures broadly confirms the link between fiscal responsibility and hierarchical procedures and transparency, Alesina and Perotti caution that further study will be needed in a number of areas. These include the need to weigh the impact of specific procedures, gauge the effect of other political and economic variables, determine when budget deficits appeared and measure the impact of institutional reforms.

Although Alesina and Perotti’s review of the literature focuses on parliamentary democracies, the experience of the United States broadly reinforces their findings. In both political systems:

• Budget deficits seem to derive from the delayed fiscal adjustment of fragmented governments (coalition government in the parliamentary systems and divided government—executive and legislative branches of different parties—in the United States).

• Budget institutions influence budget outcomes in the expected direction.

• More hierarchical institutions appear to be particularly necessary and useful in instances of fragmented government.

Alesina and Perotti emphasize that collegial institutions and fragmented governments do not in themselves cause budget deficits, but they do delay the response to fiscal imbalances once they appear. Thus, the complex interaction of oil shocks in the 1970s, lower economic growth, and aging populations, combined with certain budget procedures and fragmented government influenced both the emergence of deficits and the considerable cross-country variation in the level of the deficit.

Public Debt In Selected Industrial Countries

(gross debt as a percent of GNP)

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Data: Organization for Economic Cooperation and Development

1970.

Recommendations

Different budget procedures respond to different needs and are aimed at different goals. Since these needs and goals change over time, Alesina and Perotti counsel flexibility. A high-debt country, for example, may benefit from certain budget procedures that a low-budget-deficit country would find needlessly restraining and hierarchical. A possible solution, the authors conclude, would be contingent procedures that invoke more hierarchical procedures when the budget deficit rises above a prescribed threshold—say, 60 percent of GNP. Such a threshold would create positive incentives for those who favor deficits to be more restrained, since triggering a more hierarchical set of procedures would reduce their influence in the budget process. A possible administrative and practical headache, however, would be a debt-to-GNP ratio that oscillates around the trigger point.

To achieve greater transparency and a reduction in the scope for creative budgeting, Alesina and Perotti suggest the creation of an independent agency that “supervises the accuracy and transparency of the budget, based on a set of reasonably well-defined rules.” The budget institution’s independence should mimic that of a central bank’s. To further strengthen the independence and impartiality of this budget agency, the authors suggest using forecasts based on an average of international organization and private forecasts, employing reputable accounting firms to confirm the impartiality of the budget, and creating simple, clear, and transparent implementation guidelines to discourage creative budgeting.

Copies of IMF Working Paper 96/52, Budget Deficits and Budget Institutions, by Alberto Alesina and Roberto Perotti, 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: publications@imf.org

David M. Cheney, Editor

Sara Kane • John Starrels

Senior Editors

Sheila Meehan • Sharon Metzger

Assistant Editor Editorial Assistant

Lijun Li

Staff Assistant

Philip Torsani • In-Ok Yoon

Art Editor Graphic Artist

The IMF Survey (ISSN 0047-083X) is published by the International Monetary Fund 23 times a year, plus an annual Supplement on the IMF, an annual Index, and 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. Material from the IMF Survey may be reprinted, provided due credit is given. Address editorial correspondence to Current Publications Division, Room IS9-1300, IMF, Washington, DC 20431 U.S.A. Telephone: (202) 623-8585; or e-mail comments to imfsurvey@imf.org. The IMF Survey is mailed first class in Canada, Mexico, and the United States, and by airspeed elsewhere. Private firms and individuals are charged an annual rate of $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: publications@imf.org

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