Global Economy & Financial Markets Sustaining The Recovery

Updated: Apr 27 2004, 05:30am hrs
The global economic environment has improved significantly since we met last September in Dubai when the outlook for the global economy was weighed down by some uncertainties and risks. The recent strengthening of the global recovery process has been led by buoyant growth in emerging Asia, especially China and India and, of course, by a robust turnaround in the US. Incipient recovery appears to have set in the Euro area while the economic activity in Japan has exceeded expectations. The resurgent growth in many emerging market economies (EMEs) is now accompanied by significant resilience and EMEs are now positively contributing to the world growth. The determinants of global growth and the policy requirements for sustaining the present momentum, both at regional and multilateral levels, need to be evaluated in the light of this beginning of a significant rebalancing of economic strengths and activity.

The improved global recovery has been accompanied by a strong acceleration in world merchandise trade, particularly from emerging Asia, Japan and Euro Area. With renewed improvement in sentiment, investment has also picked-up in most regions, which should in the normal course augur well for sustaining the recovery process. Reflecting improved investment opportunities and receding systemic risks, capital flows to emerging markets have also improved. At the same time, the risk of deflation in several industrial countries has begun to subside with growing recovery and rising commodity prices. Risks have been mitigated by improved liability management through readjustment of maturity structure of external debt, build up of foreign exchange reserves, and improved credit quality.

The domestic bond market has also received added fillip in many countries. International financial markets have remained orderly and buoyant. While resilience against shocks in EMEs has strengthened, it is still an open question whether the anecdotal herding behaviour of investors is tempered by the maturation process of the investing community across the globe. This factor continues to be a critical issue for policy-makers in EMEs.

Although overall global growth prospects have improved markedly, uncertainties still remain. Significant challenges and risks which still persist include possibilities of disruptive global currency adjustments, continued structural problems and hardening of interest rates. The impact of currency and interest rate movements needs to be carefully assessed on the balance sheets of households, corporates and financial institutions. While the adjustment of the US dollar has been orderly so far, there is a need to be vigilant about inflation and interest rate risks that could be generated in the process of correction of the high order of current external imbalances.

To sustain the recovery process and to correct the global imbalances in an orderly manner, there is an imperative need for a coordinated and cooperative approach. Key elements of this coordinated approach should include different policy responses in different countries/regions. In the US, there is need to curb household and government borrowings and strengthen national savings. However, US policies would need to delicately balance a gradual withdrawal of fiscal stimulus without hurting the recovery and, at the same time, without disruptive adjustment of the US dollar.

The Euro area, which continues to depend largely on external demand, needs to pursue some structural reforms, especially labour policies, to boost domestic demand and broad-base the recovery. Japan needs to continue to take some concrete measures to strengthen its financial system, restructure the corporate sector, and reduce large fiscal imbalances. There is a growing perception that flexibility in exchange rate policies in emerging market economies in Asia is worth considering on pragmatic grounds but as appropriate to each countrys circumstances. As the recovery gains further momentum, interest rates which are at historic lows, may have a tendency to firm up. The transition to higher interest rates would have to be managed carefully, particularly in countries with high household indebtedness and exposure to housing and mortgage markets.

There is need for bold leadership in resolving some of the issues confronting the international community. Despite the fact that past episodes of crises have exposed various deficiencies of the international financial system, progress towards developing a sound system has been slow. Accumulation of foreign exchange reserves by several Asian countries seems to be not only linked to the exchange rate policies and the related trade as well as employment implications but also, to the lack of confidence of these countries in the existing architecture. Concrete steps need to be initiated in right earnest to redesign the international financial architecture.

There is also a need to move swiftly in reviving trade talks. The protectionist postures by industrialised countries need to be shed, particularly in agriculture and textiles sectors, especially when developing countries have started, at last, to get out of their protectionist mindsets. Developing countries are increasingly realising that trade is, after all, not a zero sum game but a win-win proposition for both the trading partners. In this context, as presented eloquently by most eminent policy-makers in industrialized countries, the recent protectionist measures by some countries against business process outsourcing misses out not only the efficiency gains from such outsourcing but also the employment gains from resources saved in the process and deployed in other employment generating sectors.

While it is widely recognised that rising exports could effectively reduce debt service burden, for the LICs the quantum of exports has fallen short of the desired target. In this context, there is a need to focus on remittances as a supplementary source of resources to mitigate debt service burden. However, while trade in commodities has expanded over the years, and cross border capital flows exploded, growth in mobility of labour has not been encouraging. Moreover, the demographic transition in advanced economies with a declining proportion of the population in the working-age adds urgency to the consideration of the issue of cross border mobility of labor. The International Financial Institutions (IFIs) can play a crucial role in developing a harmonised framework for enhancing cross-border labour movement and channeling of remittances.

Progress With Crisis Resolution Initiatives
Designing a globally accepted institutional framework has been the core issue for achieving private sector involvement in crises resolution. The introduction of Collective Action Clauses (CACs) in sovereign bonds is increasingly being recognized as a tool that would help mitigate the problems associated with the free rider and holdout litigation involved in debt restructuring exercises. In this context, we welcome the recent inclusion of CACs in many of the sovereign debt issues which has not resulted in any additional premium.

The role of the IMF and other fora such as the G-10 in popularising the concept has been commendable. The efforts to develop a Code of Conduct by initiatives from G-20, in addressing the coordination problems that arise in a restructuring exercise is valuable and proactive. However, a prescriptive or standardized approach should not be followed in the formulation of the Code and the role of the IFIs should be limited to providing overall support to the development of such a code. Finally, we welcome the adoption of the Evian Approach by the Paris Club for redressing debt sustainability concerns of the non-HIPC countries.

Combating Money Laundering And Financing Of Terrorism
We reiterate that India vehemently opposes all forms of terrorism. We also restate our commitment to fight against the abuses of the financial system, including money laundering and terrorism financing. In India, a comprehensive Prevention of Money Laundering Act has been passed to deal with money laundering and financing of terrorism.

We commend the Fund/Bank staff on the overall success of the pilot program and also welcome the participation by the Financial Action Task Force (FATF) and the FATF Style Regional Bodies (FSRB) in the pilot program. The primary objective of the Pilot program has been achieved through the deepening of international attention to Anti-Money Laundering/Countering the Financing of Terrorism (AML/CFT) issues. However, on AML/CFT issues, the Fund should remain within its mandate as laid out in its Articles of Agreement, without getting involved in law enforcement or non-macroeconomic issues.

Proliferation of areas beyond its core competence may dilute the Funds efficiency in its core area of functioning. Such an involvement may also not augur well for the co-operative principles that must underpin IFIs engagement in this area. It may be desirable to maintain the current policy of limiting the IMF/Bank involvement to responsibilities for assessment. For rest of the work, the independent AML experts should be financed from external resources.

IMF Quotas, Voice and Representation
The problem of a democratic deficit and transparency in IMFs governance is well-recognized. The public discussion about the process of appointing a new Managing Director has again brought this issue into sharp focus. A number of measures have been suggested to strengthen voice and representation of the developing countries. We are supportive of the proposals to provide increased administrative and technological support to multi member constituencies to increase their effectiveness. We are also open to considering additional chairs to make the two very large African constituencies more manageable. However, we have concerns that the Boards may become unwieldy, unless immediate consideration is given to merging or reducing the number of chairs allotted to countries that are one monetary union and/or one trading bloc.

We reiterate that these measures are not a substitute to real reforms, i.e., structural changes in the Board and reform of quota formulas and voting rights. It is worthwhile recalling that similar discussions last year culminated merely in some additional posts being created in the two largest constituencies. For real and substantive reform, a package of measures must be adopted simultaneously, and the central issue, namely distribution of voting rights and representation of member countries on the Executive Board, addressed squarely. We appreciate the enormous complexities involved in such an exercise, but the current state of impasse on this owes a great deal to the reluctance of the major shareholders to give up their present disproportionate strengths.

The present quotas, based on a flawed formula with variables and weights chosen to produce a pre-determined result, do not reflect positions that are truly representative of many countries profile in the world economy. A new formula based on a transparent and objective set of criteria is needed. In order to be truly representative of the size of economy and capacity to contribute to Fund resources, the chosen formula should assign maximum weights to GDP and reserves, and GDP should be computed on Purchasing Power Parity (PPP) terms. This could be accompanied by increasing the share of basic votes which have declined from 12.1 per cent of the total at the time of Funds inception, to just 2.1 per cent. It may also be worthwhile to review the requirement of supermajority for important decisions. In conclusion, we would like to emphasize the need for a comprehensive approach, as piecemeal measures implemented singly will have only a marginal overall impact for developing countries as a whole.

Statement by Y V Reddy, Governor, RBI, to the International Monetary and Financial Committee (IMFC) meeting, Washington, D.C., April 24, 2004.