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Prospects for the World Economy

26/09/1999

Statement by Hon. Giuliano Amato

Governor of the Fund for Italy

IMF Interim Committee

Washington D. C., September 26, 1999

Prospects for the World Economy

The global economic outlook has improved significantly since our last meeting. While the United States has remained the main engine of world growth, the recovery has gained strength in Europe, and, according to the most recent data, in Japan as well. In some areas of the world that experienced instability in the recent past, Asia and Brazil most notably, the balance of risks has moved away from recession towards resumption of growth earlier than expected. However, the global picture remains affected by a high degree of uncertainty, due to the persistence of imbalances in both the advanced and the emerging market economies. The uneven growth pattern of the three major industrial areas has widened current account imbalances. Moreover, the fiscal consolidation and the structural reform agenda remain largely unachieved in many emerging and transition economies. The ongoing economic recovery should not detract efforts from structural reforms and further macroeconomic stabilization.

In the United States the recovery has not lost momentum and inflationary pressures have remained subdued. A growth slowdown, which could most probably take place during the next year, seems nonetheless inevitable. A soft landing of the US economy remains the most likely and desirable scenario. However, should excessive price pressures emerge, or the dollar come under downward pressure, monetary policy might be induced to a stronger tightening than otherwise envisaged. The rise in interest rates could prove disruptive to the US equity market, prompting a sharp fall in aggregate demand and an abrupt end to the seven- year long recovery. Such events are possible, yet somewhat unlikely.

Indeed, if policies are well attuned and coordinated, the chances are that a soft slowdown of the US economy will be offset by a gradual strengthening of growth in Europe and Japan. This is the picture underpinning the WEO's short-term projections. Growth in the US should fall to 2.6 percent (from 3.7 percent), while in Japan and the Euro area it would rise to 1.5 and 2.8 percent, respectively.

However, the picture in Japan remains uncertain, notwithstanding the signs of recovery apparent in the latest output data. Confidence, in particular, remains depressed and unemployment is rising. Economic policies face formidable challenges. On the one side, the room for a further easing of monetary policy is virtually nil. On the other, a withdrawal of the fiscal stimulus is clearly premature, but the need to face up to a fiscal consolidation effort is becoming increasingly urgent. Structural policies are the only solution to set growth on a higher and sustainable path.

In the euro area the recovery is gradually picking up, particularly in the large countries. This helps to close the cyclical gap with the smaller and faster growing economies in the area. Growth is fostered by low interest rates and partly by the depreciation of the euro, without putting price stability in jeopardy. While the process for fiscal consolidation must continue towards the objective of achieving fiscal positions that are in balance or possibly in surplus, we must redouble our efforts to address the agenda of structural reforms aimed at making our economies more competitive and efficient. The reduction in unemployment remains our paramount objective. European unemployment is largely structural in nature. The current economic recovery, therefore, is unlikely to induce a significant decline in unemployment. The reform of the labor market must remain at the center of our strategy.

Developments in emerging and developing market economies are also crucial in determining the future course of the global economy. Recent events have shown that international financial markets are vulnerable to economic turmoil in emerging markets. This calls for a redoubled effort to achieve effective surveillance of the international monetary and financial system. We welcome the progress achieved in structural reform and stabilization efforts in many emerging economies. We note however that the adjustment process is still incomplete in many emerging and transition economies. A much-improved international environment and an incipient domestic recovery cannot justify any failure to persevere on the road to structural reform.

Low income countries, particularly in Asia and in Sub-Saharan Africa, are poised to benefit from the world economic recovery. Some of these countries, notably in Asia, have also provided an important contribution to regional and world economic stability. However, other countries, particularly in Africa, have largely been excluded from the benefits of world growth and international integration. The International Community has a responsibility to ensure that low income countries fully benefit from worldwide economic prosperity. The HIPC Initiative is designed to provide deeper, faster and broader debt relief to poor countries and to channel the reduction in international debt service toward the objective of poverty reduction.

Lessons from the 1990s

Several notable features of global economy in the 1990s can be singled out. First, world inflation has declined to levels unprecedented for several decades, particularly in industrial countries, reflecting to a large extent the determined effort by monetary authorities to reign in inflationary pressures. Structural factors, namely the increased degree of competition and a number of technological advances, especially in information technology, have also played a role in the process. While monetary authorities must remain vigilant to avoid a rekindling of inflation, a culture of price stability has now become strongly entrenched in our economies.

Somewhat paradoxically, greater price stability has been accompanied by increasing volatility in exchange rate markets. The exchange rates of the major currencies have indeed displayed large fluctuations. Among emerging market economies, which have become more open and integrated into the global economy, fixed exchange rates have become difficult to maintain, as demonstrated by the sequel of currency crises during the nineties. The gradual worldwide movement towards increased flexibility in exchange rates is a response to such difficulties.

Attempts at reducing exchange rate volatility by constraining the movements of major reserve currencies would be politically unfeasible and economically inappropriate. The three main areas are still too different to form a currency area. Movements in their exchange rates retain an important role in buffering cyclical divergences and asymmetric shocks. Moreover, any attempts to stabilize exchange rates among the three major currencies would involve targeting domestic policies to an exchange rate rule rather than to internal objectives. Greater stability in exchange rates would thus come at the expense of internal stability, an undesirable outcome. However, we must recognize that large fluctuations in the exchange rates of the three major currencies can have sizeable external effects on the rest of the world.

In emerging and developing market economies, the choice of the exchange rate regime must be made on a case by case basis and depends on country specific circumstances. No exchange rate regime can fit all possible circumstances. At a very general level, rigid exchange rate regimes have proven unsustainable for emerging market economies that are highly integrated in world capital markets, particularly if not supported by appropriate domestic policies. However, for countries that are experiencing hyperinflation, there can be scope to rely on the exchange rate as an anchor for stabilizing price expectations, even more so if these countries are less integrated in world capital markets. Similarly, small economies with a dominant trading partner may also find a fixed exchange rate optimal. Finally, the recent experience seems also to suggest that hard forms of rigidity, such as currency boards, tend to be more easily sustainable.

The Fund should strengthen its involvement in this area, which falls fully within its mandate. In particular, the Fund should exercise greater responsibility in (i) judging the sustainability of an exchange rate regime, (ii) conditioning its financing to the implementation of sustainable exchange rate policies and supporting policies, and (iii) helping to design appropriate exit strategies from fixed to flexible exchange rate regimes.

The increased mobility of capital flows represents the third noticeable feature in the world economy. It offers unprecedented opportunities to achieve a more efficient allocation of saving and investment resources throughout the world economy. It provides a disciplining effect on economic policies. At the same time, though, unfettered capital mobility, particularly in emerging markets, has often been associated with a boom-bust cycle with substantial costs for economic activity. Massive short-run inflows can be highly destabilizing, particularly if they are intermediated by a poorly regulated and ill-supervised banking sector. There is a strong case for well-designed market-based controls on capital inflows with a view to limiting the currency and maturity mismatches that have been at the root of most recent balance of payments crises. The case for controls on capital outflows is much less compelling: their benefits are limited; they are often used as a substitute for an appropriate policy stance; and their medium-run costs can be substantial. Moreover, the imposition of controls on capital outflows can generate negative externalities on other countries, by spreading contagion and financial instability. The Fund should be given a clear mandate to promote the orderly liberalization of capital flows within a rule-based framework.

Challenges ahead

The greater systemic risk inherent in the global economy today requires that we continue to improve our ability to forecast, prevent and manage financial crises. We welcome the progress that has been made so far in each of these directions.

Prevention is the key word. We welcome the efforts by the IMF to develop new standards in its core areas, such as the provision and the dissemination of timely and comprehensive statistical information as well as the conduct of fiscal and monetary policies. We fully support the related efforts to develop, in collaboration with other relevant bodies, adequate standards in the fields of auditing, accounting, bankruptcy procedures, corporate governance, and securities market regulations. Ways must be found to strengthen the collaboration between the IMF and the relevant institutions in these non-core areas. We must also strive to incorporate existing and newly developed standards in both the surveillance and the conditionality activities of the IMF. At the same time, we must address the concerns of many developing countries that are reluctant to accept standards developed with little or no involvement on their part and no regard with respect to their special circumstances.

One of the most critical questions within our reform effort is how to strengthen the Interim Committee. The Interim Committee is the politically and institutionally legitimate body to coordinate IMF activities with those of other international institutions and groupings. Hence we support the proposed amendment to the 1974 resolution. This entails some important changes, of which I would single out the new name, International Monetary and Financial Committee, fully reflecting the enhanced mandate of the Committee and the institutionalization of the preparatory meetings at the deputy level, which have played a valuable role in enhancing the effectiveness of the decision-making process on matters within the mandate of the IMF. This legal measure will not prejudge further institutional developments.

Another key element of our strategy towards improving the financial architecture has been to promote a greater involvement of the private sector in crisis resolution. We have experimented our strategy in a number of recent cases of countries with debt restructuring problems. These have clearly shown the shortcomings of too rigid an approach. Hence, I believe that we should favor a flexible approach based on a minimum set of principles designed to guide and reassure markets. I also think that, in financial crises involving debt restructuring, all types of financial assets should be treated equally, and no class of creditors should be regarded as privileged.

Finally, we must continue to work towards alleviation of the debt problem of the poorest countries. To this aim, we support an enhanced HIPC initiative to assure faster, broader and deeper debt relief, and to strengthen the link between debt relief and poverty alleviation. Regarding the ways to finance the enhanced HIPC, we support an off-market sale of the Fund's gold, provided that only the profits from this transaction will then be used, in order to preserve the Fund's gold holdings and, hence, its financial integrity. Italy will fully do its part in terms of bilateral contribution. Beyond contributing its SCA2 resources in the form of a grant and an SDR 250 million loan to the ESAF Trust Account, it is ready to provide, if needed, additional resources so as to fully match its share in filling the financing gap.

Recent Progress in Italy

In Italy growth prospects have improved. In particular, investments are the most dynamic component of domestic demand. As usual in a recovery, the rise in investments has mainly resulted in an increase of imports. However, the increase of the capital stock should contribute soon to a more sustained growth of domestic supply. In fact, leading indicators of industrial production are showing signs of significant improvement. Moreover, both domestic and foreign orders are rising, and industrialists' expectations on future sales are picking up.

Italian GDP is expected to grow at a rate of 1.3 per cent in 1999 and 2.2 per cent in 2000. Domestic demand (especially investments) should contribute to GDP growth more strongly than in the previous years. Thanks to better international conditions, net exports should improve significantly with respect to 1998. However, their contribution to GDP growth should remain slightly negative.

In the labor market, employment has been growing since 1996. More recently, the increase is getting momentum and is leading to a decrease of the unemployment rate, which is now below 12 per cent. Although at a slow pace, participation rates are rising as well. Given the moderate development of GDP, the positive labor market performance suggests that the employment content of growth is rising. To a large extent, this result is due to the improved employment outcome in the service sector.

Although current economic developments look brighter, Italy and many other continental European countries are still confronted with the need to close the growth gap with the rest of industrial countries. In particular, in the last decade Italy grew at a rate slightly above 1 per cent, which is around half the growth rate prevailing on average in Europe.

The Italian budget deficit as a ratio of GDP keeps declining at a sustained pace. Last March, we estimated that the deficit would reach 2.4 per cent of GDP during the current year. The most recent public finance data point to a better out turn. In the medium term, the public finance target is a balance close to zero.

Inflation in Italy is stable and low by historical standards even if marginally higher than the average inflation rate in the euro area.

The Economic and Financial Planning Document presented last June delineates the policy actions aimed at: promoting efficiency in private and public services; introducing more flexibility in the product market through improved regulation and the continuation of the privatization process; modernizing the labor market through incentives to the use of more flexible types of job contracts; lifting barriers to the growth of small firms and their expansion abroad; enhancing the education and training system and increasing investments in research; and sustaining a widespread diffusion of the information technology.

The economic situation in the countries of the constituency

In Albania the balance of payments did not deteriorate as feared in the wake of the Kosovo crisis, thanks to the prompt and extensive support of the international community and also to a firm policy stance. Over the last months the exchange rate has strengthened and foreign reserve have reached a relatively comfortable level. For the current year, GDP growth should be as expected at 8 percent, while inflation and foreign reserves should perform better than envisaged under the IMF program. The authorities are fully committed to remove all impediments to economic development. Among their priorities are private sector development, boosting foreign direct investment, strengthening security, and enhancing governance.

In Greece, despite the adverse effects of the Kosovo crisis and the recent earthquake, the economic outlook continues to be promising, with growth exceeding 3 percent for the third consecutive year. The program for accession to EMU by the year 2001 is on track. According to pre-earthquake projections, the fiscal deficit for the year 2000 is expected to decline to 1.2 percent of GDP, notwithstanding the substantial net tax reductions that were recently announced mainly for low-income tax payers. The earthquake costs will be spread over a number of years, and the government has asked the European Commission to re-route structural funds earmarked for Greece, so that earthquake-related expenditure can be co-financed.

In Malta growth has slowed down to 2.5 percent due to weak domestic demand. Inflation remains subdued, and the unemployment rate is expected to increase slightly to 5.7 percent. The government has taken actions to address the problem of a large budget deficit, which in fact should decline to 9 percent in the current year. In 2000 GDP growth is expected to accelerate slightly as domestic demand picks up. The Maltese authorities are committed to continue in the process of economic restructuring as the country continues to prepare itself for accession to the EU.

In Portugal, economic activity has slowed down but remains robust, with private consumption being the main driving force. The situation in the labor market has mirrored the cyclical position of the Portuguese economy, with the unemployment rate continuing its downward trend since 1996 and reaching 4.5 percent in the second quarter of this year. Inflation has declined to 1.9 percent, as the effects of temporary factors that influenced last year's performance seem to be unwinding. Mainly due to improvements in tax administration, current projections point to a deficit of 1.8 percent of GDP, instead of 2 percent as targeted.

The economy of the Republic of San Marino, being closely integrated with that of Italy, has benefited from the introduction of the euro in terms of inflation and interest rate reduction, and ultimately in terms of higher growth and employment. The service sector continues to enjoy an ever-increasing inflow of financial and human resources, with tourism continuing to play a predominant role.