Y V Reddy: The global economy and financial markets
Statement by Dr Y V Reddy, Governor of the Reserve Bank of India and Leader of the Indian
Delegation to the International Monetary and Financial Committee, at the 2003 IMF/World Bank
Annual Meeting, Dubai, 21 September 2003.
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Mr. Chairman,
The global economy and financial markets
Outlook, risks and policy responses
There have been several welcome developments in the global environment since we met in last April.
To our relief, several uncertainties relating to Iraq war, impact of SARS and volatility in oil prices have
turned out to be short-term and transitory in nature. Hostilities in Iraq have ended earlier than
expected. Reflecting the cessation of hostilities, oil prices reverted back to lower levels although they
have rebounded somewhat thereafter. The impact of SARS has also been successfully contained.
Financial markets, which were in a state of flux, especially equity markets, have also rebounded in
many countries. Interest rates in several countries have continued to decline to historically low levels.
With the receding global risks, financing conditions for the emerging markets have eased considerably
and spreads for many countries have declined significantly. Despite these favourable developments,
the world economic outlook continues to be fragile and weighed down by downside risks. Labour
market conditions continue to be soft. Data on industrial production and trade growth indicate marked
slowdown. Rise in oil prices in the recent weeks is also worrisome. Investment activity in major
industrial countries is yet to show a decisive turnaround, although it is heartening to note that signs of
pick-up in growth in the US are discernible, of late.
During our last meeting in Washington, it was expected that the global recovery could resume in the
second-half of the year if the war in Iraq was short. While the growth performance of the Asian region,
the Middle East, CIS countries, the African countries and the Latin American countries has shown
resilience, in view of the lack of sustained recovery in the industrialised countries, several new
uncertainties have arisen. It is not clear as to what extent the US dollar would depreciate and how the
global economy would adjust to that. It is difficult to say as to how and when global macroeconomic
imbalances would get corrected. Low inflation combined with weak global recovery has increased the
risk of deflation in several industrial countries.
While faster global recovery may be the immediate global concern, there is also a need to address the
structural issues so as to place the global recovery on a sustainable path. In spite of large cross
currency movements, misalignments continue to persist in the face of the continued global
imbalances. In this context, further easing of monetary policy and stronger structural reforms in the
euro area have assumed critical importance. Despite the limits set by the Growth and Stability pact on
the permissible extent of fiscal expansion, cyclical expansion may be fully allowed, at least, to
neutralise the impact of shortfall in revenue realisation in the face of an economic slowdown. If the
sources of global growth are not diversified across regions and if countries continue to rely on the US
demand to increase their exports and thereby grow faster, the case for US depreciation would become
stronger. Rebalancing of growth dependence, therefore, would be critical to contain volatility in key
exchange rates.
Several emerging market economies have been contending with the challenge arising from current
account surpluses and pressures on the exchange rate to appreciate. Large reserve accumulation by
some Asian emerging market economies, in a way, reflects their lack of confidence in the international
financial architecture. The improved reserve position of emerging market economies will surely provide
"self insurance", giving the necessary flexibility for exchange rate management. As the duration of the
global slowdown becomes more prolonged, fiscal and public debt problem of many countries could
intensify further. Fiscal adjustment, though necessary, would have to be weighed carefully and is best
calibrated with the pace of global recovery.
Against the backdrop of several adverse developments including severe drought, uncertain global
environment and considerable hardening of oil prices, the Indian economy performed reasonably well
during 2002-03. The growth rate of the Indian economy at 4.3 per cent, though lower than expected,
was one of the highest in the world. This indicates the growing resilience acquired by the Indian
economy over the years. With a good monsoon so far this year, a strong recovery in agricultural output
is expected. The output for the industrial sector is expected to be reinforced by the renewal of
agricultural activity, the abiding strength of export growth and the improved environment for new
investments as indicated by a surge in the production of capital goods and non-oil imports. Overall, the
economy is expected to perform much better in the current year. The growth process would be
facilitated by benign inflationary conditions, adequate liquidity coupled with soft interest rates and
strong external sector. As a result of various structural reforms, the Indian financial system is
increasingly becoming more sound, stable and efficient. The overall policy environment has fostered
macroeconomic stability, and generated optimism regarding the medium-term. The main challenge in
macroeconomic management today is reducing the high fiscal deficit and an improvement in the
quality of fiscal adjustment. The recent enactment of the Fiscal Responsibility and Budget
Management (FRBM) Act is a step in this direction, which will put in place the institutional structure for
greater transparency in fiscal operations as well as a phased decline in the Central Government's
borrowings. This will "crowd in" private sector investments for the achievement of self-sustaining,
accelerated growth.
Sri Lanka has entered into a new phase of social and economic revival with the return of peace and a
wave of new economic reforms. Progress is being made towards consolidation of macro economic
stability and acceleration of economic growth. Such policies are being complemented under the
Fund/Bank supported PRGF/EFF and PRSC programs. The economy of Sri Lanka is expected to
grow by 6 per cent this year and inflation is on a declining trend. External reserve position has also
improved. Economic prospects having improved significantly, investor confidence has been growing.
The approval of the PRGF for SDR 347 million for Bangladesh in June 2003 is a satisfying event this
year. The country is expected to improve upon its already better economic performance, continue
strengthening of external sector and make further progress towards structural reforms particularly
addressed to poverty alleviation. The country has developed a competent and laudable economic
management. The Fund guidance on reforms in a number of areas has been extremely valuable.
It is refreshing to see increasing recognition being paid to the non-quantifiable but a critical factor to
the Bhutanese development goals viz., Gross National Happiness (GNH). Factoring GNH, at least
implicitly, as an objective of IFIs, could be explored.
Importance of the Doha Development Agenda
As one of the founding members of the GATT (1947) and the WTO (1995), India remains firmly
committed towards the multilateral approach to trade relations. India is committed to ensure that the
sectors in which developing countries enjoy a comparative advantage are adequately opened up to
international trade. The November 2001 declaration of the Fourth Ministerial Conference in Doha,
Qatar, provides the mandate for negotiations on a range of subjects. The progress so far has been
reviewed at the recently concluded fifth Ministerial Conference in Cancun, Mexico. The conference
reflected the diversity of views and positions, particularly in relation to agricultural subsidies and the
Singapore issues.
We believe that once the concerns of the developing countries are adequately reflected in the
discussions, it will pave the way for rapid development in multilateral trading environment. In the
context of developed countries there is a need for reduction of high tariff and subsidies to agriculture,
providing effective market access, facilitating trade in services, and, whenever necessary, giving effect
to the clauses extending "Special and Differential treatment" to developing countries in the
implementation of these WTO Agreements. There is little doubt that potential gains from free and
equitable multilateral trading system far outweighs the costs, and, therefore, it is of utmost importance
that the international community endeavour to reach a mutually agreed agenda within the WTO
framework.
Strengthening IMF surveillance and promoting international financial stability
Enhancing economic performance, resilience to crises and financial stability through IMF
surveillance
A major initiative towards preventing crisis has been enhancing the effectiveness of surveillance, and
incorporation of a fresh perspective to the Fund's analysis and policy recommendations. Considerable
work has already been done with a view to preventing crisis, including the emphasis on public and
external debt sustainability assessment, analyses based on financial soundness indicators (also
known as Macro-Prudential Indicators) and balance-sheet weaknesses, preparation of ROSCs and
reporting of political economic issues in the staff report. However, several more steps are required to
improve the efficacy of the surveillance mechanism. First, the vulnerability assessment exercise for the
emerging market economies needs to be improved. Secondly, early warning system models today are
far from perfect and suffer from high false-to-signal ratios.
As regards strengthening of surveillance, we have come to a stage when we have all the tools
available, but there are still doubts about their effectiveness for a variety of reasons. We should
recognize that origins of crises in the past were also in the industrial countries and advanced financial
centers leading to sudden capital flow reversals. While markets have started to learn to discriminate
among countries, there is still a long way to go. Therefore, in surveillance, the Fund has a significant
role in building confidence of both borrowers and lenders, which is important for an orderly market
behavior. We are indeed happy to note that the Management has proposed an even handed approach
to the Fund's surveillance in this regard. Secondly, the fundamental question relating to Fund's
surveillance is what purpose it serves and to whom it is meant for. The objective is no doubt to identify
vulnerabilities and pre-empt crises from occurring or minimizing severity of such crises, when they
occur. Some clarity and transparency about the target of surveillance would be in order. In this
respect, the Fund has to take a view on whether the Fund's assessment is meant for national
governments in its role as a confidential advisor, or for the market players who in any case rely on
alternative avenues for assessing publicly available information. It needs to be mentioned that
immediate market reactions to sensitive information may have serious implications on members'
efforts to address a problem in hand or their plans for addressing an impending crisis. Our view is that
the Fund should preserve its role as a confidential adviser and the Fund's assessment should be to
help national authorities in reducing the recognition lag and recommending measures that could help
in containing vulnerability. However, we are not opposing the dissemination of relevant information
giving due consideration to the specific circumstances that members and the Fund are dealing with.
The role of the CCL and precautionary arrangements in crisis prevention
The Contingent Credit Line (CCL) was expected to play a critical role to serve as a precautionary line
of defense, reducing vulnerability and bolstering investor confidence in eligible emerging market
economies. Unlike other existing Fund facilities, the objective behind CCL was to prevent crises by
making available adequate liquidity upfront to a member with sound fundamentals so as to deal with
the pressure of contagion. CCL, however, has not been used by any member so far because of a
number of concerns, including: (a) the entry problem - i.e. the fear that access under CCL would
convey a negative signal to the market, (b) the exit problem - i.e. the uncertainty about the withdrawal
of eligibility, (c) insufficient automaticity, and (d) stringent pre-qualifying norms. The very fact that no
country has so far requested the Fund for using CCL resources suggest that it did not serve the
intended purpose and it should be allowed to expire in November 2003. While we support the option of
allowing the facility to expire, however, if there is a distinct possibility of evolving workable strategies in
the near future, we are willing to go along with a consensus for further review.
The existing precautionary arrangements could be suitably modified so as to enhance the capacity of
the members to prevent capital account crises. We suggest that since the objective behind a modified
precautionary arrangement is to prevent a capital account crisis, the access limit under the first
purchase must be large (i.e. a top-down staircase pattern of disbursement rather than the present
bottom-up staircase pattern) and the performance criteria must be relevant to deal with a capital
account crisis (implying less emphasis on conventional performance targets and complete avoidance
of the saw-tooth problem). Since the IMF would endorse the policy framework of a country before
entering into a precautionary arrangement, repeated programme interruption and subsequent granting
of waivers would need be avoided. Overemphasis on "safeguarding Fund resources" would reduce the
effectiveness of a precautionary arrangement by subjecting the programme to performance criteria
that would not be critical to deal with the capital account crisis.
Progress with crisis resolution initiatives
Efforts are also underway to develop Collective Action Clauses (CACs) to augment a market-led
process for restructuring of sovereign bonds. It is heartening to note that rapid progress has been
made in promoting the inclusion of CACs in international sovereign bond issuances.
We welcome the positive developments relating to the development of a voluntary Code of Conduct to
deal with debt restructuring. We urge that the Code should be developed in full and voluntary
agreement of creditors and debtors and neither a mechanistic nor a prescriptive or standardized
approach should be followed.
In recent years, increasing attention has been accorded towards development and implementation of
standards and codes to strengthen the international financial architecture. The IMF and the World
Bank have taken the initiative to monitor and assess member countries' financial sectors as also their
observance of standards and codes through Reports on the Observance of Standards and Codes
(ROSCs). In future, ROSCs will help national authorities develop their own reform plans, assess
compliance with international standards and codes, and serve, if published, as a signal of their
policies' enhanced transparency. They will also provide helpful inputs for IMF surveillance and
technical assistance.
Accelerating poverty reduction and strengthening sustainable economic growth in low income
countries
Millennium Development Goals, the Monterrey Consensus, and progress with the PRSP
approach: the role of the IMF
Monterrey has generated consensus on the issues that need to be addressed to effectively alleviate
poverty. This consensus needs to be transformed into concrete action urgently. A comprehensive and
transparent system to monitor progress towards fulfilling the Millennium Development Goals (MDGs)
of poverty reduction, sustained economic growth, and promotion of sustainable development would
need to be developed. The IMF has attempted to achieve this through two programmes - the PRSP
and the HIPC initiative. The PRSP has been instrumental in addressing medium term policy reforms to
promote broad-based growth and reduce poverty. The initial experience with PRSP approach
underlined the need for (i) improving public expenditure management (PEM) systems, (ii) building
capacities for monitoring and evaluation, and (iii) strengthening and institutionalising participatory
processes. There is a need for working with other donors for improving the effectiveness of aid in
these countries. A strengthened PRSP approach will certainly emerge as the crucial link between
national public accounts, donor support, development outcomes needed to meet the MDGs, the
operational basis for Fund concessional lending and for debt relief under the Enhanced Heavily
Indebted Poor Country (HIPC) Initiative.
While an important constraint in improving low-income countries' economic growth is inadequacy of
finance, this problem could be mitigated by ensuring their access to the private capital also.
Institutional change along with appropriate economic policies are most critical. Strong institutions could
provide necessary support that cuts across level of economic development, country grouping, and
geographical and historical endowments. However, there are genuine uncertainties surrounding as to
what constitute an appropriate institutional reform agenda. Keeping in view the country-specific
imperatives, it is felt that case-by-case study could be the preferred approach to initiate institutional
reforms. This would allow appropriate innovation and adaptation to suit the local conditions.
Minimising vulnerability to exogenous shocks
The role of Fund Assistance for countries facing exogenous shocks can hardly be overemphasised,
given the fact that these shocks can have negative impact on developing countries' growth,
macroeconomic stability, debt sustainability and poverty ratios. The impressive gains made by
developing countries in recent years can be considerably eroded when they face such exogenous
shocks. It is a welcome step on part of the Fund to include a systematic focus in Surveillance and fund
assistance programmes towards tackling the adverse effects of exogenous shocks, with a view to
reducing response delays. Also welcome is the recent initiatives to strengthen existing instruments
with the Fund, e.g., Emergency Natural Disaster Assistance, Compensatory Financing Facility (CFF),
Stand by credit tranches, and augmentation of PRGF programmes.
We believe that there is a clear need to establish a broad menu of instruments, and apply the
appropriate instrument depending on the nature of the shock, based on country-specific requirements.
Sufficient flexibility is needed on part of multilateral agencies to meet the financing and adjustment
needs of low income countries affected by exogenous shocks. Enhanced financing may be warranted
depending on the intensity of shocks.
Progress with the HIPC initiative
The HIPC initiative has existed for some time, with the prime motive of alleviating the unsustainable
external debt burden of low income countries. Despite a commendable coordinated programme of
various multilateral/bilateral creditors, HIPC initiatives faced difficulties due to inadequacy of resource,
global economic slowdown, delay in implementation of policy reforms in highly indebted countries, and
litigations by non-participating creditors for recovery of dues. There is a critical need for recognising
country specific constraints and work out an agenda for reducing the debt burden of HIPC countries.
However, debt restructuring in these countries must look beyond outright write-off of debt and explore
innovative measures such as debt-equity swaps, use of export proceeds to donor countries to retire
debt, and stepping up investment opportunities in these countries.
Progress reports
IMF quotas and governance
Recent measures to increase administrative and technical support to the Executive Directors of the
developing and transition countries are welcome. However, the present quota formulas do not reflect a
position that is truly representative of a country's profile in the world economy. Despite increasing
recognition of this fact, the consensus to bring about the required reform continues to elude us. We,
therefore, believe that the responsibility rests primarily with the developed countries who, as the
majority shareholders, must demonstrate the will to reform the international financial architecture in
line with the changed realities.
The quota review exercise in future should ensure adequate, equitable and appropriate representation
of developing countries. Such a broader representation of the developing countries would enhance the
acceptability, ownership and effectiveness of the IMF's programs and policies. While arriving at the
quotas, the GDP must be computed on a PPP basis, as this is a more representative measure to
define the relative position of a country in the world economy. Lack of data availability has often been
cited as one of the significant hurdles to the adoption of the PPP based approach. We suggest that the
Fund should work on how this deficiency could be satisfactorily addressed.
Combating money laundering and financing of terrorism
The Indian government vehemently opposes all forms of terrorism and all activities abetting it. We fully
endorse the UN Security Council's Resolutions on combating the financing of terrorism (CFT). We
restate our commitment to fight against the abuses of the financial system, including money laundering
and terrorism financing. In India, we have already enacted a comprehensive Prevention of Money
Laundering Act and there exists adequate legal and institutional framework to address ML&FT. We
commend the Fund, the Bank, as well as all member countries, for the adoption of a comprehensive
single assessment methodology for AML/CFT. Cooperation among FATF, IMF, World Bank and other
multilateral institutions will ultimately lead to more efficient use of resources and a better co-ordination
of the policies, taking into account country-specific problems for combating this menace.
While we would like to await the full report of the pilot program for detailed evaluation and discussion
of the future road map, we have noted the observations made in the MD's report that the assessments
completed or underway reveal not only a great deal of priority attached to meeting international
standards by authorities but also a wide range of compliance levels.
In the countries in my constituency, adequate legal and institutional frameworks to address the money
laundering and financing of terrorism are in place. In India, this has been further strengthened by
enacting a comprehensive Prevention of Money Laundering Act. This Act had factored in the relevant
portions of the FATF-40 recommendations. India, an active member of the APG (a FATF-style
Regional Body), has completed and sent in FATF's Self-Assessment Exercise on the Eight Special
Recommendations. Membership of FATF is in an advanced stage of processing with the FATF
Secretariat. In order to strengthen international cooperation, exchange of information and outreach,
India is also in the process of upgrading its Economic Intelligence Bureau into a full-fledged FIU. We
had attended the last two plenary sessions of the Egmont Group with Observer status.
Independent Evaluation Office
The establishment of an Independent Evaluation Office (IEO) in July 2001 by the IMF marks an
important step towards enhancing the transparency of activities and economic policy formulations. IEO
has produced extremely insightful reports on the IMF's role in the recent capital account crises and
fiscal adjustment in Fund supported programs, providing objective assessments of arguably some of
the most controversial and contentious issues related to the functioning of the Fund. We are
impressed by the iterative process by which the IEO continues to improve upon the quality of its work,
and the Fund, particularly the Managing Director is responding to suggestions and benefiting from
them.