According to an interim forecast of the United Nations Department of Economic and Social Affairs, gross world product (measured at market exchange rates) will grow by about 3¼ per cent for 2005, following 4 per cent growth in 2004. However, the world economy is facing headwinds as well as some systemic risks, so that there is a danger that the deceleration may be more marked than anticipated.
After the widespread improvements in growth in 2004, two main factors have combined to produce the lower expectations for 2005. The first is that policy makers are aiming to slow both of the two main engines of global economic growth - the United States and China – in order to avoid overheating. The second is the direct and indirect negative effects on the real economy of the unexpected persistence of higher oil prices. Beyond these on-going developments, there is the possibility that the global imbalances might unwind in a highly deflationary manner.
Weakening or weak growth in the developed countries is accounting for a large part of the global economic deceleration in 2005 and will, in turn, have a negative effect on growth in the rest of the world. With macroeconomic policy becoming less accommodative, growth in the United States is expected to decline by about 1 per cent in 2005 from the 4.4 per cent achieved in 2004. Growth in Japan and the euroarea averaged 2½ per cent and 2 per cent respectively in 2004 but slowed as the year progressed. In both cases, the downward movement is expected to be reversed in 2005, but to a lesser extent than previously anticipated - the average for in 2005-2006 is not expected to exceed 2 per cent in either case. Most other developed countries –notably Australia, Canada, New Zealand, the United Kingdom and the new members of the EU—outpaced Japan and the euroarea in 2004 but, with the exception of Canada, are expected to experience a deceleration in 2005. Driven by higher world commodity prices, in particular for oil and gas, growth in the Commonwealth of Independent States was almost 8 per cent in 2004, but is expected to moderate to around 6 1/2 per cent in 2005 and 2006.
The most encouraging feature of the world economy at present is the high and unusually universal growth being achieved by developing countries. In 2004, all major developing regions, except Africa, grew by more than 5 per cent. In the case of Africa, the historically rare characteristic of its performance was that growth in sub-Saharan Africa (excluding Nigeria and South Africa) also exceeded 5 per cent and it was the weaker performance elsewhere in Africa that pulled down the regional average. In 2005, growth is expected to decelerate modestly in all regions except Africa, with only Latin America forecast to fall below the 5 per cent threshold. As a further sign of the improvement in Africa, aggregate growth for the region is expected to rise to 5 per cent.
In part, this improvement in growth reflects sounder economic conditions in the developing countries themselves, as reflected in the key macroeconomic balances –both fiscal and external deficits have been reduced, with some having been transformed into surpluses, most notably in the case of the current account. Inflation has been reduced and financial positions have been strengthened in most of the countries that have access to international capital markets. Reflecting these improved domestic conditions and confidence, domestic demand has become an increasingly strong component of growth in many developing countries.
The widespread nature of growth in developing countries in 2004 and into 2005 was attributable to the complementary impacts of the two main engines of global economic growth –the United States and China. Buoyant domestic demand in the United States boosted the exports of manufactures from developing countries, including China, while China’s manufacturing sector increased global demand and prices for exports from developing countries that remain heavily dependent on primary commodities, including oil. Meanwhile, for capital-importing developing countries, conditions in international markets not only remained calm but interest rates generally declined.
The risk is that these conditions may change. The formerly unexpected persistence of higher oil prices will pose difficulties for oil-importing developing countries as their terms of trade deteriorate. Although the developed countries are the major consumers of oil, the oil intensity of growth is now higher in developing countries than in developed countries, with the result that the damaging impact of higher oil prices is likely to be the greatest for oil-importing developing countries. Higher oil prices are causing trade balances to deteriorate, inflation to increase and, where oil subsidies are in effect, fiscal balances to weaken. In addition their direct contractionary effects, these developments are likely to prompt restrictive policy responses as developing countries seek to maintain their hard-won macroeconomic stability.
In both of the two current engines of growth, policy makers are seeking to avoid overheating by unwinding stimulatory measures. This will have a direct negative impact on their demand for imports from the rest of the world, with any strong slowdown in China having also effects on commodity prices. The tightening of monetary policy in the United States will also raise interest costs for countries borrowing on international capital markets. However, the largest risk in this respect is the possibility of an abrupt and disorderly reaction to the present global imbalances; such an occurrence would probably result in a substantial increase in United States’ long-term interest rates, to the detriment of the many developing countries that have dollar-denominated debt.
Most developing countries have strengthened their economic policies and their economies and many have raised economic growth to a level, which, if sustained, would enable them to make some meaningful strides in reducing poverty. A primary goal of the international community for the immediate future should be to ensure that this progress is not derailed by events beyond these countries’ control.
Global imbalances have worsened since the previous meeting of the IMFC although so far without any apparent significant repercussions other than their role in the continued depreciation of the dollar. For its part, that depreciation, despite having lasted some three years, does not appear to be having any corrective effect on the imbalances. Meanwhile, understanding of the factors giving rise to the imbalances has increased, with Chapter III of the World Economic Outlook providing the latest review of an extensive literature.
The most disturbing implication of current global imbalances is that it has enhanced, for a seventh consecutive year, the net transfers of financial resources from developing to developed countries. In 2004, the largest proportion of the increase in net transfers was the result of strong growth in export revenues that led to current account surpluses in some countries. However, these countries chose to use the surpluses as a means to improve their self-insurance against possible balance-of-payments difficulties, either by increasing their foreign exchange reserves or by reducing their foreign debt, rather than allow their currencies to undergo temporary and possibly excessive appreciation in the presence of substantial volatility in the exchange rates of the major industrialized countries. The perceived need for such self-insurance should be seen as a major deficiency of the international financial system. Referring to the current pattern of negative net resource flows, a member of the Board of Governors of the US Federal Reserve System has noted that “In the longer term … the current pattern of international capital flows –should it persist—could prove counterproductive… Basic economic logic thus suggests that, in the longer term, the industrial countries as a group should be running current account surpluses and lending on net to the developing world, not the other way around.” The same point could be argued on moral and ethical grounds.
Possibly of more immediate consequence, however, it is questionable whether financial markets will allow the imbalances to continue at their present level for an extended period. Some observers argue that the current situation could continue in a similarly benign fashion for some time, but the conclusion of Chapter III of the World Economic Outlook seems more compelling when it argues that “ultimately exchange rates and trade balances will need to adjust and to adjust substantially”. In the meantime, the possibility of an abrupt, contractionary and globally damaging correction persists. As indicated above, the development prospects of many developing countries are likely to be adversely affected by such a development –one not of their own making. As called for in the Communique of the IMFC Meeting in October 2004, “policies to support an orderly resolution of the global imbalances are a shared responsibility”. As with most adjustment programmes, efforts to correct the imbalances should not focus only on the deficit countries because such an approach is likely to be excessively contractionary. While this should serve as a general principle, it is particularly pertinent in the present case when the deficit country is a primary source of growth for the world economy. Some correction of the United States fiscal deficit and an improvement in its private savings rate seems indispensable, but the contractionary effects of such action should be counterbalanced by expansionary measures elsewhere. In many cases, the necessary measures will require longer-term structural changes which, as the World Economic Outlook notes, may be politically difficult to initiate. However, it is in both the national and international interest to seize the opportunity offered by the present period of widespread growth to address these challenges, rather than having to confront them under the more difficult circumstances that might develop if no action is taken.
Private capital flows have come to play the dominant –though unstable—role in development finance, eclipsing both official bilateral and multilateral flows and some have argued that they have diminished the need for increasing official flows. Indeed, much of the Monterrey Consensus dealt with the measures that could be taken by developing countries to provide an attractive domestic environment to support private foreign investors. However, the experience of private flows since the 1980s has shown that these flows tend to be concentrated in developing countries that have already made substantial progress in increasing their per capita incomes and achieving high growth. As a result, they cannot be considered as a substitute for official flows and debt reduction in support of achieving the MDGs. On the other hand, these flows tend to be more volatile than official flows and to be procyclical.
This can be seen in the experience of frequent emerging market crises due to capital surges and capital flow reversals. Even net direct investment flows that have become the most important source of external finance for developing countries have shown pro-cyclical behavior in recent years. While efforts to improve regulation and supervision of the financial institutions of developing countries to strengthen their financial systems is important to reduce the possibility of changes in capital flows producing crises, it is still important for countries to have international support to provide liquidity to prevent major income and wealth losses.
In this regard, the capacity of developing countries to manage the maturity structure and currency composition of debt needs further improvement. An integrated asset-liability structure is needed which also encompasses domestic debt and off-balance sheet items. In this context, the IMF has been advising developing countries to develop domestic bond markets to raise funds through long-term fixed-interest securities denominated in the local currency as an alternative to borrowing from abroad. While this may be a solution in some middle-income countries, there are serious structural constraints in many low-income countries, largely because of the limited depth and liquidity of their financial sectors to reduce their reliance on external financing, particularly ODA.
While the IMF has continued to adjust and adapt its various lending programmes to changes in the global economy and the needs of those countries seeking its support. However, the Contingent Credit Line has been allowed to lapse without any alternative to assist countries with sound policies to cope with potential capital-account crises stemming from sudden outflows of capital. There has been a continued increase in the costly build-up of precautionary reserves as a form of self-insurance against volatility in international capital flows. Thus, there remains a critical need for effective progress in this area.
Debt sustainability and debt relief have been integral part of recent discussions on the international efforts to reach the MDGs. In this regard, it is imperative that increased aid is not used to meet outstanding debt service, in particular to the multilateral financial institutions. Developing countries qualifying for debt reduction have been encouraged to incorporate the MDGs in their Poverty Strategy Reduction papers, but occasionally meeting these expenditures has caused them to incur additional indebtedness. The result has been that some countries that have emerged from the HIPC process have not achieved conditions of debt sustainability.
There is currently a great deal of discussion on a more appropriate definition of debt sustainability for use in determining debt reduction. The Secretary General’s recent Report cuts through these difficulties by suggesting that debt sustainability be simply defined as the level of debt that allows a country to achieve the Millennium Development Goals and reach 2015 without an increase in its debt ratios. For most HIPC countries, this will require exclusively grant-based finance and 100 per cent debt cancellation. These are issues that must be addressed at these Meetings as many heavily indebted non-HIPC and middle-income countries debt sustainability will require significantly more debt reduction than has yet been proposed.
The emphasis placed on achieving debt sustainability for those countries facing the greatest difficulty in meeting the MDGs should not divert attention from the fact that many low- and middle-income countries that are not eligible for debt relief under the HIPC initiative face debt problems of similar magnitude for which a satisfactory solution still remains to be found. Because many of these countries carry a sizeable amount of debt owed to private creditors, efforts need to be continued to find an internationally agreed mechanism that could help prevent financial crises in the future and lead to more equitable burden sharing between debtors and creditors in crisis situations. In the absence of a statutory mechanism modeled on national bankruptcy legislation in developed countries some sovereign debtors and private creditors have been attempting to develop voluntary "Principles of Stable Capital Flows and Fair Debt Restructuring in Emerging Markets", but progress has been slow. Whether voluntary efforts, such as these principles, can provide a sufficiently strong basis for an effective crisis resolution mechanism has thus yet to be tested.
The Monterrey Consensus, in line with virtually every development document negotiated in the United Nations since 1960, notes that each country has primary responsibility for its own economic and social development and calls for the national policies and development strategies to be supported by national consensus. However, for such policies to be fully nationally owned and for countries to be fully responsible they must be given appropriate responsibility in international decision-making and norm-setting institutions. The Consensus thus called for a search for pragmatic and innovative ways to further enhance the participation of developing countries and countries with economies in transition in these international organs. This issue is now part of the agenda of both the International Monetary and Finance Committee and this Committee. While some initial steps have been taken, such as the establishment of an analytical Trust Fund to support the African Chairs at the Bank, further action have been limited to technical work on the issue by the staff of the Bretton Woods Institutions. However, despite recent World Bank reports noting that the issue needs to be resolved as a matter of urgency, decisions on the proposals contained in the technical studies have been continually referred for further study. It is becoming increasingly clear that bold political decisions, similar to those that must be adopted to ensure success in achieving the MDGs will be required. This Committee would seem to be the appropriate place to start.
It is important to note that the call to increase responsibility through more equitable representation was not limited to the Bretton Woods institutions but to all international decision-making and norm-setting institutions whose decisions influenced conditions in developing countries. In these other institutions, with the possible exception of the WTO, where formal and informal steps to make the negotiation processes more inclusive and transparent have been taken, progress towards formal representation has been disappointing.