Y V Reddy: A central banker's perspective of the world economy
Statement by Mr Y V Reddy, Governor of the Reserve Bank of India and Alternate Governor of the
Fund for India, at the Joint Annual Discussion of the Boards of Governors, on the occasion of the 2003
IMF/World Bank Annual Meeting, Dubai, 23-24 September 2003.
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World Bank Group
International Bank for Reconstruction and Development
International Finance Corporation
International Development Association
International Centre For Settlement Of Investment Disputes
Multilateral Investment Guarantee Agency
International Monetary Fund
Mr. Chairman:
Since we met last in April 2003, there have been some signs of improvement in the global
environment. Recent economic data of some countries as well as some forward looking market
indicators, particularly those relating to financial markets indicate that we may be seeing some signs of
global economic recovery. While we share the view that this could indicate the beginning of a stronger
recovery, we recognize that considerable risks still persist, though the upside risks appear to outweigh
the downside risks.
The outlook for the United States, Euro area and Japan presents a mixed picture. If current trends are
any indication, global recovery in the near-term would be led by the United States. However, the
widened and historically high twin deficits, in fiscal and current accounts, of the United States pose the
threat of possible disruptive adjustment of the US dollar against other major currencies. We recognize
this as a necessary short term trade-off for realizing medium-term gains. We, therefore, urge all the
major currency areas to coordinate their policies and to carefully monitor currency market behavior to
minimize potential adverse repercussions on financial markets and on sustainability of global
economic recovery. The recent depreciation of dollar has, to some extent, minimized the possibility of
such disruptive adjustment. Further, continuing robust productivity trends support the strong prospect
for recovery in the United States. In this regard, there is considerable merit in the U.S. evolving a
medium-term fiscal framework to bring its fiscal position on to a sustainable path.
The outlook for the Euro area seems rather flat. As in the US, there is a comparable element of
trade-off. While the monetary stimulus provided by the European Central Bank is encouraging, scope
exists for using fiscal stimulus in a more countercyclical manner. In our view, the Stability and Growth
Pact should be applied in a flexible manner to allow the automatic stabilizers to run their courses in the
short-term, even if that results in marginal breaching of ceilings on fiscal deficits, especially in
countries where this could trigger recovery.
We welcome the reforms undertaken to improve the accounting and auditing standards and corporate
governance practices both in the US and the EU. These improvements are partly reflected in the
strengthening of corporate bond and equity markets. The primary bond market issues have become
more buoyant. Sovereign yields, in general, have declined, combined with a compression of yield
spreads. We consider these developments as supportive of increased capital flows into emerging
markets and for the general strengthening of intermediation in international capital markets. Though
there was a temporary upward shift in the long-term yields of bonds in the US, potential for significant
risks of further increase in bond yields appear remote. First, the policy interest rates have declined to
historically low levels and upward hikes in quick succession are therefore unlikely. The housing and
mortgage markets as also bond markets cannot withstand such sudden shocks. Second, the
probability of inflation undershooting and the consequent adverse implications for deflationary
expectations are feared by many.
The question also remains as to how long and to what extent the US would lead the global recovery. It
is important for the EU and also Japan to intensify structural and financial sector reforms with
redoubled vigor. In some countries, labor and product market reforms should receive priority as
important components of such reforms. We encourage the Euro area countries to take steps to
promote productivity and efficiency gains, given the minimal scope, in the short-run, for achieving
higher labor participation rates. The necessity of achieving these gains, and a general increase in
demand arises from the impending medium-term fiscal risks associated with demographic trends and
the attendant pension reforms. Similarly, we recognize that more vigorous steps may help Japan
counteract deflationary expectations an address the fragility of the financial system. In the
mediumterm Japan also requires further restoration of fiscal stabilization.
Growth is expected to remain robust in most emerging market economies and, to some extent, in
Africa. These are propelled in no small measure by stronger macroeconomic policies, structural
reforms and improvements in the institutional structure. Prospects have also improved due to general
improvements in major industrial countries, favorable terms of trade due to non-oil commodity price
increases, and improved financial market conditions, especially in the bond markets. It is imperative
that greater resources flow into these countries to help sustain growth. The current favorable financial
market conditions, no doubt, provide an opportunity for these countries to steer ahead with remaining
structural reforms and achieve greater fiscal and external sector sustainability.
Among the developing countries, emerging countries in Asia continue to remain a bright spot. They
have shown extraordinary resilience in the face of the recent global slowdown and continue to exhibit
healthy recovery. While timely and complementary policy actions taken by a number of countries to
facilitate the revival of external demand and expand intra-regional trade are promising, medium-term
prospects would depend on the recovery in major industrial countries.
The scope for exchange rate flexibility, particularly in view of the recent build up of reserves in many
countries, has generated a lot of debate over the last few months. This calls for a more dynamic and
pragmatic approach in the analysis of recent trends in exchange rates and reserve management
practices keeping in view country specific circumstances. The recent strengthening of external position
of many developing countries through building up substantial foreign exchange reserves can be
viewed from several perspectives. First, it is in part, a reflection of the lack of confidence in the
international financial architecture. International liquidity support through official channels is beset with
problems relating to adequacy of volumes, timely availability, reasonableness of costs and above all,
limited extent of assurances. Second, it is also a reflection of efforts to contain risks from external
shocks. Private capital flows which dominate capital movements tend to be pro-cyclical even when
fundamentals are strong. It is therefore necessary for developing countries to build cushions when
times are favorable. High reserves provide some self-insurance which is effective in building
confidence including among the rating agencies and possibly in dealing with threat of crises. Third, the
reserve accumulation could also be seen in the context of the availability of abundant international
liquidity following the easing of the monetary policy in industrial countries. The resultant excess
liquidity flowed into the emerging markets. In the event of hardening of interest rates in industrialized
countries, this liquidity may as quickly dry up; in that situation, emerging market should have sufficient
cushion to withstand such reverse flows of capital. Fourth, and most important, the reserve build up
could be the result of countries aiming at containing volatility in foreign exchange markets. It should be
recognised that the self corrective mechanism in foreign exchange markets seen in developed
countries is conspicuously absent presently among many emerging markets.
It is also necessary to recognize that developing countries face major challenges in their effort for
sustained economic growth which could enable them to make a significant impact on poverty
reduction. Recent studies by the World Bank indicate that there would be considerable shortfalls in
achieving the Millennium Development Goals (MDGs). These failures would not only be limited to
some under-performing low income countries; even countries which have made rapid strides in
sustained economic growth over the past decade, would not be able to meet critical goals. The level of
development assistance currently available and even the additional commitments made at Monterrey,
and subsequently, would not be sufficient to meet the minimum financing needs. Developing countries
have huge unmet financing needs relative to MDG targets and even with their best efforts, they would
not be able to make up the deficiency. There is a very strong case for substantially stepping up the
quantum and improving the quality of development assistance.
There are two aspects to this which we would like to stress. One, is the need to make allocation of
development assistance to countries equitable. The guiding principles should be the incidence of
poverty and the effectiveness of poverty reduction efforts. This is best done in multilateral settings so
that allocation based on national or strategic considerations are kept to the minimum. The breadth of
their work, especially the analytic services and the richness of their development experience improve
the quality of policy dialogue. There is also the need to reduce transaction cost of development
assistance through better harmonization of procedures and processes. The Rome initiative needs to
be followed up and bilateral donors should look at ways of working with multilateral institutions so that
common mechanisms for project preparation, appraisal, procurement, monitoring, reporting, auditing,
etc. could be evolved. Another way would be to cofinance projects and programmes that recipient
countries draw up and avoid running parallel stand-alone projects that yield sub-optimal results and
strain country capacities.
Developing countries have been taking courageous steps in reforming their policy environment,
improving their institutions of governance and in general, widening, deepening and making more
equitable the delivery of services to the poor. Timely and productive development assistance as well
as increased access to markets are required to complement and strengthen these efforts. Developed
countries must be prepared to play the role of partners in this process as they agreed to do at
Monterrey. All players in the development process - developing countries, developed countries and the
multilateral institutions - have to work to bring about greater accountability. The monitoring of policies,
actions and outcomes needed to achieve MDGs can be a useful tool to bring about increased
effectiveness of the development process. While this would require considerable efforts at improving
the capacities in developing countries, particularly in gathering reliable and accurate statistical data,
such efforts should be a part of the overall development process and should not be seen as an end in
itself. Side by side, we need to develop strong partnerships so that country ownership is assured.
Further work is also required in order to enhance the voice and participation of developing and
transition countries in the multilateral institutions. While we appreciate that there are no quick fixes, we
would stress that on-going dialogue and efforts to evolve solutions that better reflect changed realities
is the way forward.
Together, we would work towards improving the environment where we see the benefits of economic
growth percolating to those who have been hitherto denied and to those who have suffered painful
adjustments. There is no single mantra that would work everywhere and our policies should recognize
this. But, if we are able to develop a real partnership, with each nation allowed to exploit its
comparative advantage, and not be held back by artificial barriers and constraints, there is no reason
why we will not succeed.