©1998 International Monetary Fund

WORLD ECONOMIC AND FINANCIAL SURVEYS

WORLD ECONOMIC
OUTLOOK
and
INTERNATIONAL CAPITAL MARKETS
Interim Assessment
December 1998
A Survey by the Staff of the
International Monetary Fund

I N T E R N AT I O N A L M O N E TA RY F U N D
Wa s h i n g t o n , D C
 ©1998 International Monetary Fund

World economic outlook (International Monetary Fund)

World economic outlook: a survey by the staff of the International
Monetary Fund.—1980– —Washington, D.C.: The Fund, 1980–
v.; 28 cm.—(1981–84: Occasional paper/International Monetary Fund
ISSN 0251-6365)
Annual.
Has occasional updates, 1984–
ISSN 0258-7440 = World economic and financial surveys
ISSN 0256-6877 = World economic outlook (Washington)
1. Economic history—1971– —Periodicals. I. International
Monetary Fund. II. Series: Occasional paper (International Monetary
Fund)
HC10.W7979 84-640155
338.5’443’09048–-dc19
AACR 2 MARC-S
Library of Congress 8507
Published biannually.
ISBN 1-55775-793-3

The cover, charts, and interior of this publication

were designed and produced by the IMF Graphics Section

Price: US$36.00
(US$25.00 to full-time faculty members and
students at universities and colleges)

Please send orders to:

International Monetary Fund, Publication Services
700 19th Street, N.W., Washington, D.C. 20431, U.S.A.
Tel.: (202) 623-7430 Telefax: (202) 623-7201
E-mail: [email protected]
Internet: http://www.imf.org

recycled paper
Contents

Page
Assumptions and Conventions vii

Preface ix

Chapter I. Containing the Risks to the World Economy 1

The Crisis Intensifies up to Early October and Then Eases 1
Implications for the World Economic Outlook and Remaining Risks 4
Policy Requirements 5
Systemic Issues Arising from Recent Financial Market Turbulence 14

Chapter II. The Crisis in Emerging Markets 17

Russia’s Financial Crisis 18
Deleveraging and the Terms and Conditions of Market Access 21
Spillover Effects Among Emerging Markets: The Extent of Differentiation 30

Chapter III. Turbulence in Mature Financial Markets 35

Recent Developments 36
Significance for Economic Activity 40
Systemic Aspects of Mature Market Turbulence 46
Shortcomings in Risk Management and Implications for Prudential
Regulation and Supervision 60

Chapter IV. Implications for the World Economy:

Revisions and Risks to the Projections 66
Key Revisions to the Projections 66
Japan and Emerging Market Economies in Asia: When Will the Recessions End? 68
Effects of the Russian Crisis on the Domestic Economy and
Other Countries in Transition 74
Brazil and Other Emerging Market Economies: Effects of the Global Crisis 75
North America and Europe: To What Extent Is Growth Slowing? 78
Global Financial Flows and Current Account Balances 83
Alternative Scenario 83

Annex
Emerging Market Banking Systems 87
Asia 87
Latin America 90
Eastern Europe and Russia 91

Statistical Appendix 92
Assumptions 92
List of Tables 92

Boxes
1.1. Brazil’s Financial Assistance Package and Adjustment Program 8
1.2. Recent Developments in the Japanese Financial System 11

iii
 CONTENTS

Page

2.1. Malaysia’s Capital Controls 22

2.2. Hong Kong’s Intervention in the Equity Spot and Futures Markets 30
3.1. Recent Dollar/Yen Exchange Rate Movements 43
3.2. What Is the Implied Future Earnings Growth Rate that Would Justify
Current Equity Prices in the United States? 48
3.3. Leverage 51
3.4. The Near Collapse and Rescue of Long-Term Capital Management 54
3.5. Risk Management: Progress and Problems 58
3.6. Supervisory Reforms Relating to Risk Management 62
4.1. Is China’s Growth Overstated? 78

Tables
1.1. Revisions to World Growth Projections 4
2.1. Sovereign Credit Ratings of Emerging Market Borrowers 19
2.2. Russia in International Capital Markets 23
2.3. Emerging Markets’ Debt Trading Volume 26
2.4. Emerging Market Bond Issues, Equity Issues, and Loan Commitments 27
3.1. Claims of Banks in BIS-Reporting Countries on Selected Emerging
Markets as of June 1998 42
4.1. Overview of the World Economic Outlook Projections 67
4.2. Advanced Economies: Real GDP, Consumer Prices, and Unemployment Rates 68
4.3. Selected Advanced Economies and Regions: Importance of Merchandise
Export Markets in 1996 69
4.4. Selected Regions: Importance of Merchandise Export Markets in 1996 71
4.5. Selected Asian Economies: Macroeconomic Indicators 72
4.6. Selected Developing Countries: Real GDP and Consumer Prices 73
4.7. Countries in Transition: Real GDP and Consumer Prices 74
4.8. Selected Latin American Economies: Macroeconomic Indicators 76
4.9. Developing Countries, Countries in Transition, and Selected Newly
Industrialized Asian Economies: Net Capital Flows 84
4.10. Selected Economies: Current Account Positions 85
4.11. Alternative Scenario: Simulation Results 86
A1. Asia: Estimated Costs of Bank Restructuring 88

Figures
1.1. World Industrial Production 2
1.2. Financing Conditions for Emerging Markets 3
2.1. Emerging Markets: Maturing Eurobonds 18
2.2. Russia: Federal Government Domestic and External Debt 21
2.3. Secondary Market Bond Spreads and Equity Market Returns 24
2.4. Secondary Market Yield Spreads on U.S. Dollar-Denominated
Eurobonds by Selected Emerging Markets 25
2.5. Stock Market Total Return Indices 28
2.6. Private Capital Flows to Emerging Markets 31
2.7. Brazil: Domestic Debt and Foreign Exchange Flows 32
2.8. Interest Rates, Exchange Rates, and Reserves 33
3.1. Major Industrial Countries: Stock Market Price Indices 35
3.2. Major Industrial Countries: Nominal Interest Rates 36
3.3. United States: Yields on Corporate and Treasury Bonds 37
3.4. United States: Corporate Bond Market 38
3.5. United States: Developments in Fixed-Income Securities Markets 39
3.6. Major Industrial Countries: Effective Exchange Rates 40

iv
 Contents

Page

3.7. Selected Countries: Bilateral U.S. Dollar Exchange Rates 41

3.8. United States: Equity Market Performance 46
4.1. Prices of Crude Petroleum and Nonfuel Commodities 66
4.2. Major Industrial Countries: Indices of Monetary Conditions 69
4.3. Selected European Countries, Japan, and the United States: Indicators
of Consumer and Business Confidence 70
4.4. Selected Economies: Export Market Growth 77
4.5. Major Industrial Countries: Output Gaps 80
4.6. United States: Private, Public, and Foreign Net Saving 81
4.7. Selected European Countries: Real Total Domestic Demand 82

World Economic Outlook and Staff Studies for the World Economic Outlook,
Selected Topics, 1992–98 101

v
Assumptions and Conventions

A number of assumptions have been adopted for the projections presented in the World
Economic Outlook. It has been assumed that real effective exchange rates will remain constant
at their average levels during October 19–November 4, 1998 except for the bilateral rates
among the European exchange rate mechanism (ERM) currencies, which are assumed to re-
main constant in nominal terms; that established policies of national authorities will be main-
tained; that the average price of oil will be $13.39 a barrel in 1998 and $14.51 a barrel in 1999,
and remain unchanged in real terms over the medium term; and that the six-month London in-
terbank offered rate (LIBOR) on U.S. dollar deposits will average 5.5 percent in 1998 and 5
percent in 1999. These are, of course, working hypotheses rather than forecasts, and the un-
certainties surrounding them add to the margin of error that would in any event be involved in
the projections. The estimates and projections are based on statistical information available in
mid-December 1998.

The following conventions have been used throughout the World Economic Outlook:
... to indicate that data are not available or not applicable;
— to indicate that the figure is zero or negligible;
– between years or months (for example, 1997–98 or January–June) to indicate the years
or months covered, including the beginning and ending years or months;
/ between years or months (for example, 1997/98) to indicate a fiscal or financial year.
“Billion” means a thousand million; “trillion” means a thousand billion.
“Basis points” refer to hundredths of 1 percentage point (for example, 25 basis points are
equivalent to !/4 of 1 percentage point).
In figures and tables, shaded areas indicate IMF staff projections.
Minor discrepancies between sums of constituent figures and totals shown are due to
rounding.
As used in this report, the term “country” does not in all cases refer to a territorial entity that
is a state as understood by international law and practice. As used here, the term also covers
some territorial entities that are not states but for which statistical data are maintained on a sep-
arate and independent basis.

***

Inquiries about the content of the World Economic Outlook, including questions relating to
the World Economic Outlook database and requests for additional data, should be sent by mail,
electronic mail, or telefax (telephone inquiries cannot be accepted) to:
World Economic Studies Division
Research Department
International Monetary Fund
700 19th Street, N.W., Washington, D.C. 20431, U.S.A.
E-mail: [email protected] Telefax: (202) 623-6343

vii
Preface

This interim update of the IMF’s latest regular reports on the World Economic Outlook (pub-
lished in October 1998) and International Capital Markets (September 1998) provides a pre-
liminary assessment of the unusual turbulence in international financial markets during much
of the period August–November 1998, and its implications for the global economic outlook
and for policy.
The analysis and projections contained in this report are integral elements of the IMF’s sur-
veillance of economic developments and policies in its member countries, developments in in-
ternational financial markets, and the global economic system. The survey of prospects and
policies is the product of a comprehensive interdepartmental review of world economic devel-
opments, which draws primarily on information the IMF staff gathers through its consultations
with member countries. These consultations are carried out in particular by the IMF’s area de-
partments together with the Policy Development and Review Department and the Fiscal
Affairs Department. For its evaluation of developments in financial markets, the report also
draws, in part, on informal discussions with commercial and investment banks, securities
firms, stock and futures exchanges, and regulatory and monetary authorities.
The analysis in this report has been coordinated in the Research Department under the gen-
eral direction of Michael Mussa, Economic Counsellor and Director of Research. The project
has been directed by Flemming Larsen, Deputy Director of the Research Department, together
with Charles Adams, Assistant Director for Capital Market Studies, Graham Hacche, Assistant
Director for the World Economic Studies Division, Donald J. Mathieson, Chief of the
Emerging Market Studies Division, and Garry J. Schinasi, Chief of the Capital Markets and
Financial Studies Division.
Primary contributors to this report also include John H. Green, Andrew Tweedie, Mark
De Broeck, Charles Kramer, Jorge Roldos, Ranil Salgado, and Harm Zebregs. Other contribu-
tors include Peter Breuer, Burkhard Drees, Subir Lall, Douglas Laxton, Joaquim Levy, Sandy
MacKenzie, Alessandro Prati, Anthony Richards, and Cathy Wright. The Fiscal Analysis
Division of the Fiscal Affairs Department computed the structural budget and fiscal impulse
measures. Gretchen Gallik, Mandy Hemmati, Yutong Li, Advin Pagtakhan, Subramanian
Sriram, Peter Tran, and Kenneth Wood provided research assistance. Allen Cobler, Nicholas
Dopuch, Isabella Dymarskaia, Yasoma Liyanarachchi, Olga Plagie, and Irim Siddiqui
processed the data and managed the computer systems. Susan Duff, Caroline Bagworth, Sheila
Kinsella, Rosalind Oliver, Lisa Marie Scott-Hill, Ramanjeet Singh, and Adriana Vohden were
responsible for word processing. James McEuen of the External Relations Department edited
the manuscript and coordinated production of the publication.
The analysis has benefited from comments and suggestions by staff from other IMF depart-
ments, as well as by Executive Directors following their discussion of the report on Decem-
ber 16, 1998. However, both projections and policy considerations are those of the IMF staff
and should not be attributed to Executive Directors or to their national authorities.

ix
 ©1998 International Monetary Fund

I
Containing the Risks to the World Economy

strengthen the resilience of capital markets in the face

T urbulence in world financial markets in recent
months has raised questions about certain fea-
tures of financial systems in the mature economies
of future shocks.

and has heightened uncertainty about global eco-

nomic prospects. The crisis in Russia in mid-August, The Crisis Intensifies up to Early October
coming in the wake of the Asian crisis, led to a drying and Then Eases
up of private financial flows to emerging markets, a
broader increase in risk aversion among financial Through the late spring and summer of 1998, devel-
investors, and concerns about a global credit crunch. opments indicated a further deepening and broadening
As a result, through early October fears escalated that of the global economic slowdown that was in train fol-
the current economic slowdown might continue to lowing the financial crisis that had erupted in south-
widen and deepen in 1999. Partly in response, mone- east and east Asia in the second half of 1997. Among
tary policies have been eased throughout the indus- the countries at the center of the Asian crisis, the con-
trial countries and in some emerging market tractions in demand and output proved much more se-
economies. Together with several other positive de- vere than generally expected in the early stages of the
velopments, the easing of monetary conditions has crisis. In Japan, a key export market for Asian crisis
helped to restore calm in financial markets. But while countries, recession deepened considerably, adding to
the danger of a global recession does seem to have di- concerns about the health of its banking system.
minished, the supply of funds to most emerging mar- During this period, pressures mounted on the Chinese
ket economies is still sharply reduced, and conditions renminbi and the Hong Kong dollar. Russia’s and
in financial markets remain fragile in several respects. Ukraine’s continued failures to tackle budgetary im-
It would therefore be premature to consider the diffi- balances were other factors unsettling financial mar-
culties to be over. The IMF staff’s projections for kets, and a number of emerging market countries in
world growth in 1999 have been revised further other regions experienced recurrent exchange market
downward—but not substantially, and by much less pressures amid concerns about the sustainability of fis-
than in the two preceding issues of the World cal or external imbalances. In North America and
Economic Outlook. The risks appear to remain pre- western Europe, growth appeared to be generally well
dominantly on the downside, however. sustained, indeed to be strengthening in some cases,
but the impact of the Asian crisis was beginning to be
***
felt, particularly in the industrial sector (Figure 1.1),
The purpose of this Interim Assessment is threefold. and there were concerns that buoyant stock markets
First, given recent concerns about the risks to the might undergo sharp corrections if the growth of ac-
global economy, the report reassesses world economic tivity and corporate profits began to slow. These prob-
prospects and the policies needed to contain the global lems and risks were highlighted in a draft of the
financial crisis and to foster recovery, taking into ac- October 1998 World Economic Outlook, prepared in
count new information available since the October early August 1998. That document revised down
1998 World Economic Outlook was finalized. Second, sharply projected world growth in 1998 from 3 to 2!/2
the report attempts to shed light on the apparent dis- percent, and in 1999 from 3#/4 to 3!/4 percent, and cau-
proportionality between the extraordinarily high de- tioned that a significantly worse outcome was clearly
gree of turbulence seen recently in both emerging and possible. The potential for a broader and deeper eco-
mature financial markets and the seemingly more lim- nomic downturn stemmed from a multitude of inter-
ited scale of the “triggering events,” the most impor- related risks that made the economic situation unusu-
tant of which were probably the Russian crisis and, ally fragile. Viewed in isolation, any one of the risks,
subsequently, the near collapse of a highly leveraged though serious, might not be sufficient to raise con-
hedge fund, Long-Term Capital Management (LTCM). cerns about a sharper global slowdown. But the inter-
Third, the report seeks to identify some of the most related nature of these risks, with the scope for conta-
critical shortcomings in private and public risk man- gion and chain reactions this implied, warranted the
agement systems that need to be addressed to attention of policymakers around the world.

1
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

In the event, the effective devaluation and unilateral

debt restructuring announced by Russia in mid-August
triggered a series of sharp market corrections indicat-
ing a generalized increase in perceived risk or risk
aversion. Yield premia for emerging market bonds
rose sharply, almost across the board, to an average of
1,700 basis points in early September from below 600
basis points in most of 1997 and early 1998; equity
prices fell sharply in both emerging and mature mar-
kets; and exchange market pressures intensified in
Figure 1.1. World Industrial Production1 many emerging market countries. As a by-product of
(Percent change from a year earlier; three-month these developments, many international investors and
centered moving average; manufacturing) banks suffered substantial losses, especially on highly
leveraged investment positions, which in turn gave
The slowdown in world industrial activity since mid-1997 has
been most pronounced in Asia but has also been apparent in
rise to margin calls and a rush to raise liquidity that ex-
North America and Europe. There have been signs of recovery in acerbated the decline in the prices of many financial
some Asian countries in recent months. assets. The widespread flight to quality and liquidity
gave rise to a severe tightening of credit conditions,
20 not only for emerging market borrowers but also for
non-prime corporate borrowers in some mature mar-
kets, especially the United States. These developments
15 led the staff to revise down further their projections for
Asia
world growth in 1998 and 1999 to 2 percent and 2!/2
percent, respectively, in the World Economic Outlook
published in October 1998, in which staff warned
10 (page 1) that:
Chances of any significant improvement [in world
growth] in 1999 have also diminished, and the risks of
5 a deeper, wider, and more prolonged downturn have
World escalated.
Developments since early October have been more
reassuring, helping to restore a measure of calm to fi-
0
United States,
nancial markets. This can be attributed in large part to
Canada, and a number of policy actions, including:
western Europe

–5 • Easing of interest rates by central banks in most

1991 92 93 94 95 96 97 Nov. industrial countries, including the United States,
98
Canada, the United Kingdom, and the member
countries of the prospective euro area.
Sources: WEFA, Inc.; OECD; and IMF, International Financial • In Japan, new policy measures to address banking
Statistics. sector problems and announcements of further
1Based on data for 32 advanced and emerging market economies rep-
fiscal actions to stimulate demand. A significant
resenting about 75 percent of world output. The world total includes
five emerging market countries (Argentina, Brazil, Chile, Hungary, and strengthening of the yen, especially vis-à-vis the
Mexico) that are not included in either of the two subtotals. Data dollar—attributable partly to these policy actions
through 1994 exclude Indonesia. by Japan, but also to the easing of interest rates in
the United States and, perhaps most important, to
technical factors related to the unwinding of short
yen positions (as discussed in Chapter III)—has
helped to improve financial market confidence in
the rest of Asia, although it is likely to have a neg-
ative short-term impact on Japan’s own economy.
• Commitments and actions by Brazil to address its
chronic fiscal imbalances, and the large-scale sup-
port of the international community, agreed
in mid-November, for a strong program to fore-
stall a financial crisis that would potentially have
severe contagion effects on other emerging mar-
ket countries.

2
 The Crisis Intensifies up to Early October and Then Eases

• Continued progress with stabilization and reform

in the Asian crisis countries implementing policy
programs supported by the IMF. With current ac-
count balances having moved into surplus and fi-
nancial market confidence having begun to re-
cover, the strengthening of exchange rates has
allowed monetary policy to be eased, which in
turn has helped to boost equity markets. With fis-
cal policies also having become expansionary, the
easing of macroeconomic policies has signifi-
cantly improved the prospects for recovery to Figure 1.2. Financing Conditions
begin in the course of 1999. This is not to deny for Emerging Markets
that slow progress with reform in some areas—
such as corporate debt workouts—threatens to re- Bond yield spreads for emerging market countries have declined since
tard growth in east Asia for some time. mid-September, but gross capital flows have remained depressed.
• Progress toward implementation of the IMF quota 1800
Bond Spread1
increase and the New Arrangements to Borrow (basis points)
(NAB), which have improved the international 1600
community’s ability to assist countries in the res- 1400
olution of financial crises;1 the Miyazawa initia- 1200
tive to provide assistance to the Asian crisis coun-
tries; and the proposal by Group of Seven (G-7) 1000
Finance Ministers and Central Bank Governors, 800
in their end-October statement, to enhance financ-
600
ing facilities in the IMF and World Bank to help
ward off destabilizing financial market contagion, 400
along with their reaffirmed commitment to move 200
1992 93 94 95 96 97 Dec. 15,
forward with the agenda to strengthen the archi- 98
tecture of the international financial system.2
500
Also helpful has been the avoidance of protectionist Gross Private Financing 2
(billions of U.S. dollars)
and other market-closing measures in the large major- 400
Total
ity of countries, including those that have suffered issuance
competitiveness pressures and financial strains.
300
The positive impact of these policy actions on finan-
cial markets is particularly evident in the strong re-
bounds in global equity prices. With respect to emerg- 200
ing market countries, secondary market bond yield
Asia 100
spreads have declined significantly, although they gen-
erally remain well above levels observed prior to the
Russian crisis in August (Figure 1.2). Access for emerg- 0
1995 96 97 Dec.
ing market countries to external borrowing has also 98
begun to ease, and there have been a number of new
debt issues. There have as well been signs of greater
Source: Bloomberg Financial Markets, LP.
1J.P. Morgan Emerging Market Bond Index (EMBI, Brady narrow)
sovereign spread over the theoretical U.S. zero-coupon curve.
1The increase in IMF quotas of 45 percent, from SDR 146 billion
2Three-month moving averages; annualized.
(about $206 billion) to SDR 212 billion (about $300 billion), will
take effect when member countries having not less than 85 percent
of the total of present quotas have consented to their quota increases.
The timing of ratification is still difficult to predict because parlia-
mentary approval is needed in many countries. The New Arrange-
ments to Borrow (NAB), which took effect on November 17, 1998,
doubles the amount previously available under the General Arrange-
ments to Borrow to up to SDR 34 billion (about $48 billion). The
NAB is a set of credit arrangements between the IMF and 25 mem-
bers and institutions to provide supplementary resources to the IMF
to forestall or cope with an impairment of the international monetary
system or to deal with an exceptional situation that poses a threat to
the stability of that system.
2See the October 1998 World Economic Outlook, Box 1.2.

3
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

differentiation in favor of countries with strong funda- Table 1.1. Revisions to World Growth Projections
mentals and credible reform strategies. Nevertheless, (Percent change in world real GDP)
gross new private financing flows have only recovered
World Economic
slightly so far, and considerable uncertainty persists Outlook Issued 1997 1998 1999 2000
about the willingness of international banks to maintain
or extend credit lines to emerging markets. In mature October 1997 4.2 4.3 4.4 4.6
December 1997 4.1 3.5 4.1 4.4
markets, reduced supply of credit has been felt mainly May 1998 4.1 3.1 3.7 3.8
by lower-rated borrowers in the United States, but the October 1998 4.1 2.0 2.5 3.7
decline in new debt issues has been alleviated by the December 1998 4.2 2.2 2.2 3.5
ability of such borrowers to draw on bank credit lines.
Overall, therefore, there is some evidence that con-
ditions in capital markets have eased since early
October. But there are still signs that perceived risks, tions if private financing does not recover from
or risk aversion, are considerably greater not only than the very low levels of capital inflows observed
during those periods of 1996–97 when spreads de- since August. Indeed, private financial flows to
clined to unusually low levels, but also than has been emerging market countries in all regions may well
normal in recent years. fall short of the levels assumed in the projections.
This would necessitate greater trade adjustments
by emerging market countries through weaker do-
Implications for the World Economic mestic demand growth, currency depreciations, or
Outlook and Remaining Risks both.
• Japan’s economic outlook remains particularly un-
The latest revisions to the staff’s projections, incor- certain, and questions remain about the adequacy
porating information through November 1998, reflect and implementation of recent initiatives to turn the
the restoration of relative calm in international capital economy around. The Bank of Japan has stepped
markets. In particular, the global growth projection for up efforts to boost credit and liquidity, and further
1999 has been lowered only slightly further—to 2!/4 expansionary tax measures are being considered.
percent—a much smaller revision than those seen in the A clear risk is that confidence and demand would
last two issues of the World Economic Outlook (Table remain depressed if the restructuring and recapi-
1.1). For some countries, including Japan, Brazil, and talization of Japan’s banking sector were either de-
Russia, the outlook has deteriorated more significantly. layed or pushed through without the fundamental
The growth projections for some of the Asian emerging changes needed to convince markets that banking
market economies in crisis have also been lowered weakness was finally being dealt with.
somewhat further, reflecting the judgment that the im- • The uneven pattern of trade adjustments among
proved prospects for recovery may not materialize until the industrial countries could lead to destabilizing
well into 1999. An exception is Thailand, where GDP is movements in exchange rates among the major
now projected to rise steadily, though slowly, through- currencies. While some further appreciation of the
out 1999. Among the most encouraging aspects of the yen and the euro against the U.S. dollar seems
baseline scenario are the continued solid growth perfor- necessary over the medium term to restore a more
mance, despite modest downward revisions, of the sustainable pattern of current account balances,
United States and the future euro area, although, as rapid and large realignments could be problem-
noted below, there are downside risks in both cases. In atic. Further appreciation of the yen in the short
addition, projected growth in China has been revised term would be particularly unhelpful from the
up, reflecting stronger-than-expected performance in viewpoint of relative cyclical conditions.
the second half of 1998, partly in response to policy • The large trade adjustments resulting from the
stimulus. Australia’s economic performance has also Asian crisis could also lead to a resurgence of pro-
exceeded expectations, notwithstanding its close trade tectionist pressures, with negative repercussions
ties with the crisis-afflicted countries. for world growth.
The modest scale of the further downward revision • The strong recovery of stock markets in some
to the world growth projections for 1999 may reason- countries, especially the United States, following
ably be viewed as indicating that the global economic the recent period of market turmoil has again
situation and near-term prospects have begun to stabi- brought equity prices into a range that may not be
lize. At the same time, however, the balance of risks sustainable, especially if future corporate earnings
remains on the downside. Five such risks are of par- were to disappoint financial investors or if infla-
ticular concern. tion and interest rates were to turn upward. The
sharp deterioration in the private sector’s saving-
• Some emerging market countries will have diffi- investment balance in the United States in recent
culties remaining current on their external obliga- years, and its current, unusually large, deficit po-

4
 Policy Requirements

sition, may be attributed in part to positive wealth need for medium-term fiscal consolidation, although
effects on consumer spending from the stock mar- an important concern, is outweighed by the need to
ket boom. It underscores the potential for a stock counter the economy’s extreme cyclical weakness.
market correction to lead to a rise in saving that, Thus, in a large part of the world economy, macroeco-
although desirable and necessary from a medium- nomic policies, or at least monetary policy, are use-
term perspective, could in the short term markedly fully helping to support or stimulate aggregate demand
weaken demand, activity, and confidence. and activity. There are two main exceptions to the
scope for expansionary policies. First, in North
In addition, the baseline scenario does not incorpo-
America and western Europe, the need for medium-
rate the further decline of oil prices in recent weeks. If
term budgetary consolidation—to reduce debt burdens
the continued weakness of oil and other commodity
and to allow for future demographic pressures—con-
prices is sustained, financing constraints for many
tinues in most cases to make discretionary fiscal ex-
emerging market countries will tighten further.
pansion inadvisable, as opposed to letting the auto-
As discussed in Chapter IV, the materialization of
matic stabilizers operate. Second, some emerging
the above risks, even on a relatively moderate scale,
market economies need relatively tight macroeco-
could easily cut world growth by a further percentage
nomic policies to address unsustainable fiscal or ex-
point in 1999—and extend what would then effec-
ternal imbalances, to adjust to adverse developments
tively become a global recession at least into 2000.
in financial and commodity markets, and to regain in-
The outcome will depend crucially on policies.
vestors’ confidence.
In the Asian crisis countries, following the large
contractions of output in 1998, the main priorities are
Policy Requirements to end the decline of economic activity, limit the impact
of the crisis on the welfare of the most vulnerable, and
Recent developments have raised a number of ques-
promote the resumption of sustainable growth, includ-
tions about policies relating to the prudential regula-
ing by accelerating the restructuring of financial and
tion and supervision of financial systems, and these
corporate sectors—a key element of IMF-supported
are considered in the next section. This section focuses
programs. In Korea, Thailand, and more recently
on policies in the macroeconomic and other structural
Indonesia, the tightening of monetary policies that oc-
areas.3
curred in the wake of the crises has achieved consider-
Although macroeconomic policy requirements vary
able success in reestablishing financial stability, and
among countries, depending on priorities and eco-
the strengthening of exchange rates has allowed inter-
nomic circumstances, there has appropriately been a
est rates to be lowered significantly. In both Korea and
widespread easing of monetary policies in recent
Thailand, short-term market rates have fallen below
months. In the Asian emerging market economies in
precrisis levels of 5–8 percent, and although lending
crisis, this has been allowed by a strengthening of ex-
rates have been slower to decline owing to the burden
change rates in a context of severe economic weak-
of problem loans in the financial system, monetary
ness. In Japan, interest rates had already been lowered
conditions are now more supportive of recovery. In
close to zero, but the yen’s recent appreciation has pro-
Indonesia, also, interest rates have begun to be lowered
vided room for more aggressive injections of liquidity.
following the strengthening of the rupiah and the im-
In North America and western Europe, monetary eas-
provement of inflation prospects; assuming that pro-
ing has been a response to the weakening of growth
gram implementation remains on track, further gradual
prospects, continuing subdued inflation, and concerns
easing should be possible without undermining confi-
in the United States about strains in credit markets, as
dence. In each of these countries, the primary focus of
well as the need for convergence of short-term interest
monetary policy will need to continue to be the assur-
rates in the prospective euro area, which is now almost
ance of financial and exchange rate stability, with the
completed following the concerted reductions in early
authorities having to be prepared to resist significant
December. Discretionary fiscal easing also is appro-
downward currency pressure.
priately being used in the Asian crisis economies and
Fiscal policy, however, is available in each case to
Japan to support demand. In the case of Japan, the
support domestic demand and promote recovery. In
fact, in all three countries there is scope for fiscal pol-
3Reflecting the concerns motivating this report and its interim na- icy to provide continuing support for activity, and this
ture, the policy challenges facing the emerging market countries should help to secure a turnaround of activity in the
most affected by international financial market developments, and course of 1999. The public finances in all three coun-
the major industrial countries, are given most emphasis. In contrast, tries are sufficiently healthy to make significant fiscal
policy issues facing the smaller industrial countries and the devel- stimulus feasible without adverse financial market
oping and transition countries less closely connected to global fi-
nancial markets are generally not revisited on this occasion. They repercussions, but medium-term sustainability must be
will be considered in the next World Economic Outlook, which will safeguarded—for example, by concentrating on nonre-
appear in May 1999. current spending, including infrastructure investment.

5
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

Macroeconomic policy requirements in Malaysia are GDP projected for the current fiscal year. Although the
similar to those in the three crisis countries worst hit. A flexibility of prices and wages is promoting rapid ad-
stimulative budget was introduced in October, and justment, the short-term prospect is one of continued
there have been a number of efforts to promote private economic weakness. It would therefore not be desir-
sector credit growth. Interest rates have fallen to levels able to tighten fiscal policy in 1999, but it will be im-
similar to those in Korea and Thailand, but in the con- portant to set the current and prospective fiscal short-
text of exchange and capital controls, introduced in falls in the context of a medium-term framework to
September, that have damaged investor confidence. restore budget balance. The authorities’ announced ex-
The Malaysian authorities have recently put together a pansion of retraining and job placement schemes, and
more comprehensive strategy to restructure the bank- acceleration of labor-intensive projects, will help to
ing sector, but the credibility of the reform efforts has contain the rise in unemployment, which has risen
been undermined by the weakening of loan classifi- above 5 percent to its highest level in more than 17
cation and provisioning guidelines and by the imposi- years and seems likely to rise further until recovery is
tion of minimum lending targets (see Annex). The under way.
Philippines is more constrained in its fiscal policy than In other emerging market countries, the main prior-
the other four crisis countries, owing to its larger pub- ities are orderly adjustment to adverse external devel-
lic debt, and the authorities in any event do not have to opments, including weaker exports to Asia and lower
deal with such a large output decline as in the other commodity prices, as well as reduced capital flows;
four cases; but there too the government is contemplat- the reestablishment of investor confidence and, in sev-
ing a cautious easing of fiscal policy to support recov- eral cases, financial stability; and the reduction of vul-
ery. Market interest rates in the Philippines have come nerability to adverse shifts in investor confidence. In
down substantially from their peaks of late 1997. most cases, financial imbalances and external financ-
In China and Hong Kong SAR, the successful main- ing constraints require tight macroeconomic policies.
tenance of the exchange rate regimes has helped to re- Although these may increase the likelihood that activ-
store stability in Asian financial markets. In fact, cur- ity will weaken in the short run, forceful measures to
rency pressures have eased considerably in recent reduce financial imbalances are needed to reduce the
months in both cases, partly owing to the weakening risk of contagion, alleviate the need for monetary pol-
of the U.S. dollar relative to other major currencies. icy to defend exchange rates, and strengthen medium-
This has facilitated a lowering of interest rates in both term growth prospects.
economies. Fiscal policy is also providing helpful sup- In recent months, the main focus has been on Brazil,
port to demand in both cases. In China, increased pub- whose currency came under sustained pressure be-
lic investment has provided substantial support for ac- tween July and October because of concerns about the
tivity in 1998, but nonstate investment and exports fiscal situation and external competitiveness. Sharply
remain weak. It is unclear how slow or negative higher domestic interest rates slowed the pace of capi-
growth in other indicators of activity, such as electric- tal outflows from mid-September, but a sustainable res-
ity production and freight traffic, relate to the more olution of the difficulties, given the government’s debt-
buoyant data for GDP, especially given the limited in- service obligations, required action to reduce the fiscal
formation on the components of aggregate expendi- deficit. Anticipation of such action, the implementation
ture, including the absence of information on inven- of some early measures, and expectations of large-
tory accumulation. In fact, some observers consider scale financial support by the IMF and other multilat-
that GDP growth in China has been overestimated by eral and bilateral creditors led to a further easing of
1–2 percentage points a year for several years, and that pressures in October and early November. Agreement
the discrepancy may have increased somewhat in 1998 on the policy program and financing package was an-
(see Chapter IV, Box 4.1). While fiscal stimulus is ap- nounced on November 13 (Box 1.1). The determined
propriate, its composition should be carefully tailored and sustained implementation by Brazil, at all levels of
to ensure that unproductive spending is minimized and government, of this front-loaded fiscal adjustment ef-
the quality of growth is not compromised. Interest rate fort (including passage of measures recently delayed in
policy will need to remain cautious in light of contin- Congress), accompanied by appropriately tight mone-
uing outflows on the capital account of the balance of tary policies and wide-ranging structural reforms, will
payments. In this context, it will be important for the make an essential contribution to sustaining the im-
recent intensification of capital controls to be imple- provement in global financial market sentiment that
mented without adversely affecting legitimate trade has occurred over the past two months.
and investment activities. The recent problems in the Many other countries in Latin America have appro-
trust and investment corporations underscore the need priately adjusted macroeconomic policies to promote
for continued financial sector reform. adjustment to adverse external developments and to
In Hong Kong SAR, the fiscal position has deterio- strengthen the confidence of investors. In Argentina,
rated significantly owing to the weakening of eco- domestic demand growth has slowed considerably.
nomic activity, with a deficit of about 3 percent of Fiscal policy has been tightened significantly in the

6
 Policy Requirements

past year, but even though the fiscal deficit is now substantially from its recent level of close to 10 per-
quite small, continued consolidation may be needed, cent of GDP. It will also be important to avoid a pre-
especially given the widening of the external current mature easing of monetary policy: in fact, further
account deficit over the past two years. There is also tightening may be warranted if inflation does not slow.
scope for accelerating structural reforms that would Aside from these macroeconomic policy require-
strengthen external competitiveness by improving ments, a wide range of structural reforms are needed to
productivity and reduce unemployment by enhancing boost confidence and reinvigorate growth.
labor market flexibility. Chile has suffered a particu- The external financial crisis in Pakistan, which has
larly marked deterioration in its external accounts over been reflected in a sharp decline in international re-
the past year, and its current account deficit in 1998 serves and the accumulation of large external pay-
now seems likely to be about 6#/4 percent of GDP. ments arrears, is being addressed by a policy package
Currency pressures have been met by cuts in public entailing substantial fiscal adjustment as well as
spending and a tightening of credit conditions, as well broadly based structural reforms and the gradual re-
as by adjustments of both the width and the rate of moval of the temporary exchange restrictions imposed
crawl of the exchange rate band, and the suspension of at the onset of the crisis, and by debt relief from offi-
restrictions on capital inflows. The current account cial and private creditors.
deficit is now declining, but a stronger fiscal position Among emerging market countries in the Middle
may be required to sustain a smaller current account East and Europe region, Turkey suffered the worst
deficit and ease the burden on credit policy. In contagion from the Russian crisis in August, reflecting
Mexico, the authorities have appropriately cut govern- its close trade links with Russia and its difficult fiscal
ment spending in the face of lower oil prices, and as a position. While the country’s international reserves
result are expected to come close to achieving their have stabilized since September, domestic interest
fiscal objective for 1998 of a deficit equivalent to 1!/4 rates have remained high, partly owing to Turkey’s re-
percent of GDP. They have also tightened monetary duced access to international capital markets and do-
policy significantly to contain inflation in the face of mestic political uncertainties. The budgetary situation
the depreciation of the peso. Gains in international has remained on its adjustment track, but substantial
competitiveness and the slowing of domestic demand further progress in fiscal consolidation and structural
growth are expected to reduce the current account reforms will be important to achieve the targeted re-
deficit significantly next year. Nevertheless, recent ad- duction of inflation and to maintain investor confi-
verse developments have reemphasized the need for a dence in the face of the heavy debt-service obligations
strong fiscal reform effort to increase non-oil rev- falling due in the period ahead. In Israel, monetary
enues, reduce the vulnerability of the budget to fluctu- policy has been tightened sharply in recent months in
ations in petroleum prices, and contain the growth of the face of downward pressure on the shekel and a
current spending. Problems in the banking sector also pickup in inflation following earlier depreciation.
remain to be resolved. Venezuela and Ecuador also Many other countries in the Middle East are having
have been suffering from the weakness of oil prices, to adjust to the weakness of world oil prices, with de-
and their fiscal deficits have widened despite substan- clines in export revenues resulting in acute budgetary
tial spending cuts; further measures seem likely to be and external pressures in many of the region’s oil pro-
needed to secure financial stability. Also in Latin ducers, including some of the wealthiest countries
America, significant macroeconomic policy adjust- such as Saudi Arabia. At the same time, current condi-
ments have been announced in Colombia to address tions in global financial markets provide limited scope
large imbalances that have emerged as a result of past to offset export shortfalls through expanded foreign
policy slippages as well as adverse external develop- borrowing. Consequently, gross official reserves have
ments. In central America, economic recovery from been drawn down in a number of countries—including
the devastation caused by Hurricane Mitch in late Algeria, Iran, Oman, and Yemen—to finance sizable
October is being supported by emergency financial as- current account deficits. Given prospects for contin-
sistance from the IMF, World Bank, and other multi- ued weakness in the oil market in the period ahead, an
lateral and bilateral sources. immediate policy challenge is the adoption of mea-
In Asia, India has been experiencing a slowing of sures to restore macroeconomic equilibrium and pro-
growth in the industrial sector, accompanied by higher mote growth of non-oil activities, particularly in the
inflation that reflects agricultural supply difficulties, oil producers of the Gulf region. Efforts to restrain
rapid monetary growth, and the depreciation of the public spending, broaden the revenue base, and press
rupee since late 1997. The current account position has ahead with structural reform will all be important.
weakened, but international reserves remain comfort- Progress to date in these areas has been limited, and
able, boosted by capital inflows from nonresident further delays would risk financial instability, with po-
Indians. The first priority for macroeconomic policy is tential spillover effects on the non-oil economies in
to take decisive steps toward medium-term fiscal con- the Middle East, some of which—in particular, Jordan,
solidation, in order to reduce the public sector deficit and, to a lesser extent, Egypt—are already experienc-

7
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

Box 1.1. Brazil’s Financial Assistance Package and Adjustment Program

The terms of a $41 billion IMF-led financial assistance plementation of its structural reform agenda, and to
package for Brazil, in support of the program of adjust- achieve annual growth of GDP of about 4 percent. In the
ment and structural reform described below, were re- structural area, its privatization program was particularly
leased on November 13, 1998. Of the total amount, $18.1 successful, but it also made progress in resolving the
billion (SDR 13,025 million) would be provided by the problems of the state banks and in other aspects of fi-
IMF in the form of a three-year Stand-By Arrangement, nancial reform, deregulation, and the opening up of the
about $4 billion each from the World Bank and the Inter- economy.
American Development Bank, and $14.5 billion from 20 Notwithstanding the Real Plan’s great success in re-
governments channeled through, or provided in collabo- ducing inflation, it has not been successful in reducing
ration with, the Bank for International Settlements (BIS). the public sector deficit. After a strong initial fiscal ad-
The U.S. government is the largest bilateral contributor, justment when the Plan was introduced, the fiscal stance
with a credit line of $5 billion. There is no explicit contri- was loosened. The public sector borrowing requirement
bution from the private sector, since the Brazilian author- (PSBR) reached 6.3 percent in 1997 and is projected to
ities believed it would be most effective to seek the vol- approach 8 percent in 1998. In addition to the impact of
untary participation of international banks in a rollover of declining inflation on real expenditure, which had been
credit lines once the financial package had been arranged. held down by the lack of rapid and full indexation of
Initial contacts by the authorities with private banks sug- nominal expenditure, the weakness of the public fi-
gest that banks will hold open their trade and interbank nances reflected some basic structural problems: an ex-
credit lines. The bilateral financing is not guaranteed by cessively generous pension system, inflexibility of civil
any collateral—something that distinguishes the package service employment rules, the lack of a hard budget con-
from the one arranged for Mexico in 1995, where U.S. re- straint on subnational governments, and a distorted sys-
payment was guaranteed by oil revenues. tem of indirect taxation. The increase in the PSBR was
The financial package is significantly front-loaded, reflected in the deterioration in the external current ac-
with about $37 billion available, if needed, in the first 13 count, which is projected to reach a deficit of 4 percent
months, and carries relatively high interest rates and short of GDP in 1998.
repayment schedules. In the case of IMF funds, 30 per- The fiscal and external deficits made Brazil vulnerable
cent will be available under the credit tranches, at a float- to changes in investor sentiment and the attendant capital
ing interest rate, currently 4.25 percent, and a repayment outflows. It successfully responded to a bout of capital
period of five years. The remainder, 70 percent, will be outflows in the wake of the Asian crisis in the fall of
available under the Supplemental Reserve Facility (first 1997, mainly because of the timely response of monetary
used in the case of assistance to Korea at end-December policy and the announcement of a strong fiscal policy
1997), with a repayment period of two and a half years package. However, disappointment with slippages in fis-
and an interest rate of 300 basic points above that apply- cal adjustment in 1998 and the continued growth of the
ing to the credit tranches. In the case of the funds chan- public debt contributed to the sentiment that Brazil re-
neled through the BIS, a repayment period of two years mained vulnerable. The crisis in Russia led quickly to
will apply upon drawdown, with a 470 basis point spread pressures on emerging markets, and particularly Brazil’s
over the London interbank offered rate (LIBOR). The external capital account, as described in the text.
first tranche of $5.3 billion from the IMF became avail- Liquidation of Brazilian Brady bonds to cover losses on
able after the approval of the package by the IMF’s Russian securities and, more generally, the buildup of
Executive Board on December 2. The second tranche will short positions in Brazilian offshore debt instruments re-
become available from February 1999, or even earlier de- sulted in arbitrage by resident investors seeking the
pending on circumstances. higher return on “Brazil risk” offered by Brady bonds.
*** Nonresident holdings of Brazilian debt and equity instru-
ments were also significantly reduced, and capital out-
Background flows by residents took place in other forms. Overall,
In the four years between the introduction of the Real most of the outflows were by nonresidents.
Plan and September 1998, Brazil managed to wrench in- The government reacted initially by announcing a
flation down from rates in excess of 2,700 percent a year number of measures to increase the attractiveness of cap-
to under 3 percent. It was also able to advance the im- ital inflows; it then announced measures to tighten the

ing a drag from weaker export growth and workers’ to have been the main factor contributing to a partial
remittances. recovery of the exchange rate, which has led to re-
Among developing countries in Africa, financial bounds in bond and equity markets. Financial market
markets in South Africa have stabilized in recent stabilization has allowed monetary policy to be eased
months following the period of severe downward pres- somewhat since October. A durable strengthening of
sure on the rand in midyear, but activity has slowed economic growth continues to require structural re-
sharply. The authorities’ tight monetary policy appears form in a number of areas.

8
 Policy Requirements

fiscal stance, as well as an increase in interest rates. With Fiscal Policy

the outflow of capital continuing unabated, it hiked inter- Most of the program’s fiscal adjustment is to occur at
est rates by 20 percentage points, raising the overnight the federal government level, with about two-thirds re-
rate to over 40 percent. This stemmed but did not stop net sulting from revenue measures. In addition to an increase
capital outflows, and the government began to prepare in the tax on financial transactions, these include in-
the policy package described below and to intensify its creases in the payroll taxes paid by civil servants to fi-
dialogue with the IMF and other members of the interna- nance their pension plan, which is unusually generous.1
tional community to seek their support. The program’s expenditure cuts are intended to spare sen-
Policy Program sitive social expenditure programs. Adjustment at the
state and municipal levels is based on the increased con-
On the macroeconomic front, the program is focused trol the government has over the states’ financing
on a set of fiscal measures announced by the Brazilian sources, on the discipline imposed by the fiscal adjust-
government in late October, aimed at increasing primary ment agreements most states have signed with the federal
surpluses of the public sector sufficiently (given the as- government, and on the impact of a law imposing a ceil-
sumption that interest rates will decline gradually, from ing on the civil service wage bill in relation to revenue.
40 percent in early November to 20 percent by mid-1999 Tariff increases will raise the operating surpluses of those
in terms of the overnight rate) to arrest in 2000 the rise enterprises remaining in the public sector, and privatiza-
in the ratio of public debt to GDP. Thus the program sets tion-related investment will fall.
a target surplus of 2.6 percent of GDP for the primary Public sector structural reforms will make a growing
balance of the consolidated public sector in 1999, fol- contribution to the fiscal adjustment over time. The re-
lowed by surpluses of 2.8 percent of GDP in 2000 and cently passed constitutional amendment to social security
3.0 percent in 2001. Contributions to the fiscal adjust- will achieve expenditure economies by increasing the ef-
ment effort are expected from all levels of government, fective retirement age of participants in the private sector
and a series of expenditure-saving and revenue-raising pension scheme. The administrative reform, whose imple-
measures have been announced, some of which have al- menting legislation is now being passed, will reduce ex-
ready been enacted (see below). In terms of domestic cess staffing in the civil service at all levels of government.
public debt management, the government will aim at se- The social security reform that congress recently ap-
curing a progressive lengthening of the maturity of the proved will be bolstered by a more fundamental reform
debt and, as interest rates decline, at increasing the share that the government is now preparing, based on the prin-
of fixed-rate securities in total debt. Monetary policy ciple that what a participant, or his or her employer, con-
will continue to be conducted to support the exchange tributes must bear a reasonable relationship to the pen-
rate regime, a crawling peg whereby the real depreciates sion he or she can expect to receive. Administrative
against the U.S. dollar at a rate of about 7!/2 percent a reforms of public sector pension plans at the state and
year. Reliance on the real as the nominal anchor is seen local levels are also planned. The government has also
as the key to low inflation. The improvement in the fis- been working for some time on a reform of the country’s
cal position is to take place despite a projected decline in indirect tax system, under which the value-added taxes
real GDP of 1 percent in 1999, reflecting the high inter- administered by the states, whose bases have been eroded
est rates expected to prevail through early 1999, the fis- and whose rate structure has been affected by excessive
cal contraction itself, and slower export market growth. tax competition, will be replaced by a VAT with a com-
Economic recovery is projected to begin in the latter part mon base and rate structure. Its revenues will be shared
of 1999, with growth of 3 percent projected for 2000, between the different levels of government, and it will
helped by improvements in international competitive- probably be administered by the states.
ness implied by the crawling exchange rate peg and the
projected low rate of inflation and continued robust pro-
ductivity gains. In addition to the structural reforms of 1This payroll tax increase was voted down by the congress in
the public sector described below, the government also early December. It is to be resubmitted to the new congress in
intends to advance financial sector and labor market re- February 1999, and the government has announced that mea-
forms and to avoid reversals of the trade liberalization sures will be taken to compensate for any revenue loss resulting
program. from the delay.

Among the countries in transition, Russia continues broader culture of nonpayment in the economy. Russia
to lack macroeconomic policies that would help to re- urgently needs a fiscal policy by which the bulk of ex-
store the confidence of investors and establish the pre- penditures would be financed by tax revenues, without
conditions for sustainable growth. The central areas of resort to arrears, and whose financing would allow in-
concern remain the large underlying fiscal imbalance, flation to be reasonably well contained, without price
which has widened further since the August crisis, and controls. To reduce the deficit to the levels required,
the distortions arising from the associated arrears and measures need to be taken as early as possible to en-

9
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

hance government revenues—particularly through im- reform is essential for the economy to regain its dy-
provements in tax administration and an end to ad hoc namism and meet the needs of its aging population.
negotiated tax deductions—and to cut government The scope to reduce interest rates further has been
spending. The authorities’ current budget plans fail to very limited since the Bank of Japan lowered its oper-
meet these requirements. Macroeconomic stabilization ating target for the overnight call rate to around 0.25
will also require a monetary policy that avoids sub- percent in early September. But the marked apprecia-
stantial central bank financing of the banking system tion of the yen that occurred in early October effec-
as well as the government. The reestablishment of sta- tively tightened monetary conditions and, at the same
bility-oriented macroeconomic policies will have to be time, provided additional room for monetary easing
accompanied by actions to address severe difficulties since it substantially reduced the risk that faster mon-
in the banking system (discussed in the Annex), the etary expansion would add to destabilizing exchange
normalization of relations with creditors, and a return rate pressures in the region. Thus the Bank of Japan
to the unfinished task of structural reform, which has recently broadened the scope of its operations in
needs to be accelerated on many fronts. Strong the private debt market to boost liquidity growth and
spillovers from the Russian crisis have been felt in support private sector credit creation. These opera-
Ukraine, although continued lags in progress there tions can continue to play a useful role in helping to
with macroeconomic stabilization and structural re- moderate deflationary pressures.
form have been a greater source of difficulty. With regard to fiscal policy, increases in public works
Particularly important now is the satisfactory resolu- contracts since September indicate that the April stimu-
tion of uncertainties regarding the implementation of lus package has begun to take effect. The further pack-
the 1999 budget and the elimination of fiscal overruns. age of measures introduced in mid-November—the
In central and eastern Europe, Hungary and Poland third supplementary budget to be introduced since the
have weathered the financial market turmoil of recent beginning of the current fiscal year, on April 1—
months reasonably well: the progress in recent years promises significant additional stimulus in 1999. As a
with fiscal consolidation has helped to maintain confi- result, the fiscal tightening of 1997 will have been more
dence in their foreign exchange markets. With infla- than fully reversed. The “headline figures” referring to
tion having been reduced significantly in both cases, the size of the package—including estimates that it is
the continued improvement of external financial mar- equivalent to 5 percent of GDP—overstate its additional
ket conditions should allow domestic interest rates to stimulative effect, partly because some of the measures
be lowered gradually further. In the Czech Republic, replace temporary ones implemented earlier. The stimu-
output is estimated to have fallen by 1!/2 percent in lus to be provided by fiscal policy in the next fiscal year
1998 following a tightening of policies that was (beginning April 1999)—measured as the change in the
needed to reduce fiscal and external imbalances. Since structural general government deficit from the current
July, the strength of the koruna has allowed reductions fiscal year—is tentatively estimated by IMF staff at
in interest rates amounting cumulatively to 4!/2 per- about 1 percent of GDP; this estimate will need to be re-
centage points, which should help to ease banking sec- viewed in the light of the budget and tax policy deci-
tor difficulties and, along with a slightly expansionary sions to be made in coming weeks. The general govern-
budget, help to support the economy in 1999. ment deficit (excluding social security) would then rise
Among the industrial countries, Japan stands out as to almost 10 percent of GDP. While Japan clearly faces
the economy with the weakest growth performance in a difficult challenge of fiscal consolidation in the
the 1990s, and as the only economy in recession, hav- medium term, in the short term the paramount need is to
ing suffered four successive quarters of output decline ensure a resumption of growth. The expansionary fiscal
since late 1997. The main objective for policy contin- stance need have only modest effects on debt-servicing
ues to be to end the recession and reignite growth. A costs in view of the continuing very low level of interest
key element among the policies needed to achieve this rates; although the recent downgrading of Japan’s sov-
objective is the resolution of the problems in the bank- ereign debt by a credit-rating agency has contributed to
ing system, and in this area significant steps have re- a recent upturn in government bond yields, they remain
cently been taken (Box 1.2). The critical challenge for only a little over 1 percent.4
the authorities is still to catalyze a quick and forceful For the other industrial countries, although there
recapitalization and restructuring that will restore the have been widespread downward revisions to growth
financial health and profitability of the banking sys- projections for 1999, the outlook in most cases is still
tem, including a full and transparent accounting of fairly good. Continuing low inflation—close to zero in
banks’ financial positions to restore investor confi-
dence. But macroeconomic policies also have a major
role to play in stimulating domestic demand—a role 4For analysis of Japan’s economic crisis and policy options, see
that is facilitated by the absence of inflation and the the October 1998 World Economic Outlook, Chapter IV; and IMF,
large external current account surplus. In addition, fur- Japan—Selected Issues, IMF Staff Country Reports, No. 98/113
ther progress with deregulation and broader structural (Washington: October 1998).

10
 Policy Requirements

Box 1.2. Recent Developments in the Japanese Financial System

This box describes Japan’s new bank laws, the nation- of bad loans, in face of (among other factors) the worsen-
alization of Long-Term Credit Bank (LTCB)—a first test ing of the economy (debts of firms filing for bankruptcy
case for those laws—and the measures taken by the Bank grew by 53 percent year-on-year in October, totaling more
of Japan (BOJ) in response to the breakdown of the bank than $100 billion in the first ten months of 1998).
credit channel in Japan.1 It also briefly discusses the The passage of the new laws reduced the risk of a col-
withdrawal of Japanese banks from several foreign mar- lapse of the Japanese banking system and provided some
kets, and the implementation of Big Bang financial re- institutional and financial mechanisms that could help to
forms in the current environment. accelerate the restructuring and consolidation of the
banking system. They could lead to a quid-pro-quo be-
The Legislative Package tween banks and the government, in which heavy provi-
The key provisions in the bank laws approved by the sioning by banks would be cushioned by injections of
Japanese parliament in October are the following: public funds and buttressed by major changes in man-
• The funds available to the banking sector were raised agement structures. Steps in that direction could also be
to ¥60 trillion, with ¥25 trillion targeted to the re- supported by the provisions in the new laws that allow
capitalization of “viable banks,”2 and ¥18 trillion banks to receive funds in order to facilitate “realign-
mainly targeted to failure resolution schemes includ- ments” (consolidation) in the sector. Prospects for suc-
ing public bridge banks and the nationalization of cess are still far from certain, however. The Japanese
failed banks; ¥17 trillion continued to be reserved for framework does not yet have explicit mechanisms that
guaranteeing deposits at failed banks. would force weak but viable financial institutions to ac-
• The creation of a new high-level body (the Financial cess available public monies and undergo a fundamental
Revitalization Commission, FRC) within the Prime restructuring.3 Thus, a more effective balance still needs
Minister’s Office. This body will be responsible for to emerge within this evolving framework between es-
drafting and implementing the regulations necessary tablishing clear incentives for the largest banks to accept
for bridge banks and carrying out the nationalization recapitalization funds, and conditions that would help to
of failed banks. It will also oversee the recapitaliza- facilitate the badly needed restructuring and consolida-
tion of banks, and centralize all financial supervisory tion that is required in the Japanese financial system.
activities (the Financial Supervisory Agency will be
put under the FRC). Nationalization of LTCB
• Existing agencies (the Resolution and Collection LTCB filed for temporary nationalization on Octo-
Bank, RCB, and the Resolution and Collection ber 23, about four months after its market valuation had
Organization) will be consolidated into an asset dropped markedly, on rumors that the bank was facing
management corporation shaped along the lines of difficulties in raising funds.4 The original plan of merg-
the former Resolution Trust Corporation (RTC) in ing LTCB with the smaller Sumitomo Trust Bank was ul-
the United States. That agency will be in charge of timately abandoned, in part because of the reticence of
receiving and disposing of bad assets from banks. the latter in taking over LTCB substandard loans. In
By early December there were indications that most of September, after one of the main affiliates of LTCB with
the major banks would apply for relatively small injec- more than ¥1.5 trillion in debts (including ¥256 billion to
tions, in the range of ¥100–700 billion, with the bulk of LTCB itself and ¥150 billion to Sumitomo Trust) failed,
the resources being used for accelerating the provisioning little doubt about the bank’s insolvency remained. At the
time of the filing for nationalization, the bank declared a
1The challenges facing the Japanese banking system were ex-
negative net worth of ¥350 billion (1.5 percent of total li-
tensively analyzed in the September 1998 International Capital
abilities), including unrealized losses on securities hold-
Markets report; this box updates that analysis for the period ings. An audit by supervisors indicated that LTCB’s prob-
since July 1998. (Box continues on next page.)
2The new legislation allows “well-capitalized” banks (that is,
banks with a BIS capital ratio above 8 percent) to apply for pub- 3As part of their applications for public funds, well-capitalized
lic funds if they are participating in a bank consolidation (in- banks are required only to announce plans that include cuts in the
cluding by absorbing a failed bank) or if the capital injection number of employees, compensation, and the number of direc-
can help to alleviate the credit crunch. More generally, funds to tors; the sale of unessential facilities; and reduction of dividends.
banks deemed solvent are to be injected through the purchase of 4Until 1996 the price of LTCB’s stock hovered around ¥900.
debt instruments and stocks (typically preferred stock, or com- By April 1998, it had fallen to ¥300, dropping to ¥37 in June
mon stock in the case of severely undercapitalized banks). and ¥3 at the time of the nationalization of the bank.

some cases, after allowing for measurement biases— be diverted from the important medium-term objective
provides scope for further monetary easing if war- of reducing imbalances and debt burdens. Fiscal poli-
ranted to support demand and output growth, and also cies can, nevertheless, help to moderate the slowing of
to help stabilize financial markets. But the current eco- growth, and counter downside risks, through the oper-
nomic conjuncture does not call for fiscal policies to ation of the automatic stabilizers.

11
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

Box 1.2 (concluded)

Japan: Derivatives Positions of Selected paper on a repurchase basis in large volumes.6 On

September 9, the Bank lowered the target call interest rate
Japanese Banks
to 0.25 percent. Despite these measures, and reflecting
(Fiscal year 1997, March 1998)
the breakdown of the monetary and credit transmission
Notional Credit Equivalent1 mechanisms, bank lending dropped by 3.3 percent in the
_____________________ _____________________
Trillions Billions of Trillions Billions of 12 months to October 1998. The authorities anticipated
of yen U.S. dollars2 of yen U.S. dollars2 severe liquidity problems ahead of the end of the calen-
dar year, manifested in the growing funding difficulties
LTCB 51 425 ... ... of Japanese banks, especially abroad.7 By late October, it
IBJ 220 1,833 3.4 28.3 became evident that the liquidity injected into the
BTM3 250 2,083 ... ...
Japanese financial system was being used to finance
DKB 166 1,383 1.7 14.2
Sumitomo 182 1,517 3.8 31.7 Japanese banks’ activities abroad—including through in-
Sanwa 165 1,375 2.3 19.2 terest swaps of yen payments for dollar cash flows. Yen
Fuji 337 2,808 2.2 18.3 funds became so abundant that for a brief period in early
Sakura 107 892 1.8 15.0 November some foreign banks were ready to lend yen at
Total 1,418 12,317 15.2 126.7 negative interest rates, and the yield on treasury bills fell
below zero (see figure, upper panel).
Source: Banks’ annual reports.
1Using BIS weights. In those circumstances, the monetary authorities opted
2Using the ¥120/US$ exchange rate. for opening new channels to finance the corporate sector.
3End of FY1996. On November 13, 1998, the BOJ announced that it would
enlarge the scope for repurchasing commercial paper and
establish a new lending facility for refinancing half of the
lem assets accounted, net of provisions, for ¥4.6 trillion, new bank lending in the fourth quarter of 1998. The bank
or 19 percent of the bank’s total assets. also indicated that it would consider the purchase of bills
The new management appointed by the government issued by financial institutions and collateralized by cor-
has indicated that the bank should be privatized within a porate bonds and loans on deeds.
year but has not announced any major plan to break up Withdrawal of Japanese Banks
the bank to facilitate its sale. Since the takeover, the BOJ from International Markets
has provided LTCB with ¥5 trillion to keep credit flow-
ing to bank clients and to smooth the unwinding of In October and November 1998, several Japanese
LTCB’s off-balance-sheet positions (see table). The table banks indicated their intention to withdraw at least par-
indicates that Japanese banks in general have large posi- tially from overseas activities, which signaled a change in
tions in derivatives instruments; interest rate swaps ac- the pace and nature of a process of retrenching from in-
count for most of their notional value.5 ternational finance that had been apparent since the mid-
1990s.8 In particular, the announcement by some major
Reaction of the BOJ to the Breakdown of Monetary
Transmission Channels
6The BOJ holds about one-third of the stock of commercial
Since late 1997, the BOJ has followed an accommoda-
papers, which has grown by about 40 percent since mid-1997.
tive monetary policy stance. Throughout 1998 it has pur-
After a big surge in late 1997, the issuance of corporate bonds by
chased commercial bills and high-quality commercial Japanese firms became increasingly difficult in the course of
1998 as the credit rating of Japan and Japanese companies wors-
ened. Strong companies have issued securities backed by re-
5Disclosure rules in Japan require banks to state the notional ceivables and raised credit lines abroad, but the scope of these
and market value of their derivatives positions every half-year. forms of financing is limited.
Recently, Fuji Bank also retained a foreign auditing company to 7Large Japanese banks were also facing funding problems do-
evaluate its portfolio and risk management practices, after ru- mestically, with regional banks preferring to invest their cash sur-
mors about large losses in that portfolio depressed the bank’s pluses in government paper rather than in the interbank market.
market valuation. The audit indicated that those practices were 8The withdrawal of Japanese banks from international activi-
in line with international standards, and that Fuji’s derivatives ties has in part been driven by the Japanese prudential regula-
portfolio had not sustained extraordinary losses. (To improve tions, which allow banks without overseas activities to maintain
transparency, Fuji Bank has also disclosed the results of the self- a ratio of capital to risk-weighted assets of just 4 percent (instead
assessment of its loans.) of the 8 percent BIS ratio). In early 1998, Fuji Bank sold part of

The United States and the United Kingdom are close inflation has remained relatively subdued. In both cases,
to cyclical peaks, and in both cases signs of slowing a slowdown of growth from the above-potential pace of
growth have been evident, albeit less so in the United recent years is desirable to avoid inflationary pressures
States. Although unemployment is low in both coun- and a hard landing later on. The authorities therefore
tries, wage growth has risen only moderately, and price need to steer a balanced course between avoiding over-

12
 Policy Requirements

from the head of the FRC, prodding banks to reduce their

Japan: Selected Claims of Banks needs for foreign currencies. Because of the size of
and Interbank Offered Rates Japanese banks and the clustering in time of the decisions
to review the scope of their foreign business, the
Three-Month Euroyen LIBOR
1.2 strengthening of the yen in October could be linked to
(percent) Bank of Tokyo-Mitsubishi their retrenchment (see Chapter III, Box 3.1).
1.0
Fuji Bank A temporary reduction in the flow of private capital
0.8 from Japan to emerging markets might be expected from
that withdrawal. Nevertheless, the impact even on Asia
0.6 may be limited, because net flows from Japanese banks
0.4 have already fallen substantially in recent years (see
LIBOR fix lower panel of figure), with official capital flows playing
0.2 a greater role since the beginning of the Asian crisis. In
Barclays Bank
0.0
view of the overcapacity of the Japanese banking system,
the closure of foreign branches might represent a first
–0.2 step toward a “realignment” among top Japanese banks.
Apr. May Jun. Jul. Aug. Sep. Oct. Nov. 20
1998 On balance, the overall effect of the withdrawal (espe-
cially on mature capital markets) will depend largely on
350 whether the Big Bang financial reform will provide room
Claims of Japanese Institutions
vis-à-vis Other Asian Countries for foreign banks to intermediate a significantly larger
(billions of U.S. dollars) 300 share of Japanese saving and facilitate the recycling of
these funds.
250
Preparations for Big Bang
Hong Kong SAR 200
and Singapore Although still at an early stage, Japanese financial in-
150 stitutions are starting to respond to Big Bang.9 Tie-ups of
Japanese institutions with foreign partners have become
Rest of Asia 100 an almost daily occurrence, and several alliances among
major Japanese banks have been announced to develop
50 specific businesses. Major banks are also positioning
Dec. 93 Dec. 94 Dec. 95 Dec. 96 Jun. 98
themselves to benefit from the switch to a real-time gross
settlement payment system by the end of 2000, which
will open new business opportunities to institutions with
Sources: Bank for International Settlements; and the capacity to act as clearing banks. Some alliances have
Bloomberg Financial Markets, LP. involved the shift of profitable businesses (for example,
asset management) from old de facto publicly insured in-
stitutions into newly created institutions. The issue of the
distribution of risks in a changing environment is not,
banks of plans to close a large number of foreign however, restricted to banks. For instance, the legislative
branches and sharply contract their lending to non- requirement that the securities sector establish an indus-
Japanese borrowers was accompanied by statements try-sponsored insurance scheme has resulted in the cre-
ation of two such schemes: one for domestic houses and
its holdings in the U.S. institution, Heller Financial, and one for foreign houses that were concerned about the po-
Sumitomo sold its California bank, Zions Bancorp. Among the tential liabilities of participating in a single industry-wide
banks that have recently announced a major overseas retrench- scheme.
ment are the small city bank Daiwa (which had already been bat-
tered by its expulsion from the United States in 1995 and carries
large unrealized losses in its securities holdings), Fuji Bank, and 9See the September 1998 International Capital Markets

the relatively strong and large Sanwa and Sumitomo Banks. report for the implementation schedule of the reforms, which
Some trust banks, including Mitsubishi Trust, followed suit. On has so far been adhered to. In December 1998, the sale of mu-
its part, Nomura Securities is also retrenching, after suffering tual funds at commercial banks was further liberalized, as
large losses in its U.S. unit. planned.

stimulating demand—which would exacerbate future investment growth, significant recent inventory accu-
risks to the economy—and preventing the likely near- mulation, and the likelihood of an upturn in private
term slowdowns from turning into recessions. saving from its exceptionally low recent levels point to
In the United States, a widening external deficit overall growth falling somewhat below its potential
(partly reflecting the Asian recession), slowing private rate next year. Activity will be supported in the period

13
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

ahead by the cuts in interest rates by the Federal bility in times of turbulence such as those experienced
Reserve Board since end-September, amounting to 75 recently.5
basis points, and by the depreciation of the dollar to The convergence over recent months of short-term
which the cuts have contributed. With financial mar- interest rates in the euro area toward the level pre-
kets having stabilized and recovered in large measure vailing in Germany, France, and the other core coun-
since early October, it would now seem appropriate for tries, and the welcome reduction of interest rates in
the Federal Reserve to pause before taking further the core countries in early December from 3.3 percent
action, while being prepared both to ease again if U.S. to 3.0 percent (in terms of central banks’ operating
growth prospects deteriorate significantly, and to rates) has lowered average short-term rates in the area
tighten if inflationary pressures increase. The Federal by about 50 basis points since midyear. This decline
Reserve’s recent easing actions have been facilitated by in short-term rates has been timely in view of the
the fiscal consolidation achieved in recent years, and weakening of external conditions and the need to en-
the budget surpluses in prospect should be allowed to sure that domestic demand growth remains sufficient
accumulate to help address the social security and to sustain slack-absorbing recoveries. Given the sub-
health care financing shortfalls that are projected to dued prospects for inflation, the considerable amount
arise in the next decade as a result of population aging. of slack, and the more severe implications of down-
While it would be appropriate to let the automatic sta- side—relative to upside—risks, scope remains for ad-
bilizers operate, discretionary fiscal easing would not ditional interest rate reductions should growth
be warranted unless the slowdown were to become prospects weaken further.
much more severe than seems likely at present. As discussed in the October 1998 World Economic
Significantly slower growth is projected for the Outlook, structural fiscal positions in most euro-area
United Kingdom in 1999 than for the United States, countries still fall short of the medium-term require-
reflecting the more severe tightening of monetary con- ments set out in the Stability and Growth Pact. In some
ditions that was needed in the economic upswing to cases, including Germany and the Netherlands, struc-
hold prospective inflation to its target. With forecast tural deficits widened in 1998. However, the medium-
inflation having fallen below the target amid the dete- term shortfall for the area as a whole is not large (1 per-
rioration of global economic conditions, the Bank of cent of GDP), and some of the needed improvement
England appropriately reversed the direction of mone- can be expected to come from declining debt-service
tary policy in early October, cutting its key interest payments. Nevertheless, any move to support demand
rate between then and early December by a total of 1!/4 in the euro area other than through allowing the auto-
percentage points. Monetary policy is still relatively matic stabilizers to operate could weaken confidence in
tight, however, and there is significant scope for rates the policy framework for EMU and limit the European
to be cut further as growth weakens and inflation con- Central Bank’s room for maneuver. In this context, in-
cerns recede. creases in public investment—which would be wel-
Growth in the Canadian economy has slowed sig- come, not least because such spending has borne a dis-
nificantly since early this year, largely reflecting the proportionate share of recent fiscal adjustment—would
impact of the Asian crisis on commodity markets. A need to be compensated by other budgetary adjust-
significant depreciation of the Canadian dollar has ments. Countries need to focus their fiscal efforts on
eased monetary conditions in spite of a hike in official structural reforms—aimed at lowering the growth rate
interest rates in August that was mostly reversed in of spending and creating room for tax cuts—as part of
October and November. Particularly given the low rate a broader strategy of reforms to reduce structural
of inflation—recently in the lower half of the 1–3 per- rigidities and strengthen employment performance. In
cent target range for core consumer price inflation, on particular, labor market reforms remain crucial to bring
a 12-month basis—further interest rate reductions will unemployment down on a sustainable basis.
be warranted if the growth outlook worsens. The
strong fiscal position, meanwhile, should be main-
tained to reduce the government’s debt burden further. Systemic Issues Arising from Recent
In the euro area, the transition to a single common Financial Market Turbulence
currency at the start of 1999 is proceeding smoothly.
European Economic and Monetary Union (EMU) is a The recent turbulence in global financial markets
major achievement. The euro area will rival the United was unusual for a period characterized by relatively
States in terms of trade and output, and the role of the strong macroeconomic policies and conditions in
euro in financial transactions eventually may match many of the advanced economies. The volatility re-
that of the U.S. dollar. The impact of euro area policies
on the world economy will therefore be as important
as that of U.S. policies in fostering an environment 5For a detailed discussion of the external implications of EMU,
conducive to sustainable growth worldwide and in as well as the policy challenges facing the euro area, see the
helping to restore global economic and financial sta- October 1998 World Economic Outlook, Chapter V.

14
 Systemic Issues Arising from Recent Financial Market Turbulence

flected a sudden heightened perception of, and aver- rate spreads in key mature markets and severe short-
sion to, risk following Russia’s effective debt default term liquidity problems.
in August and an associated flight to quality. Emerging The severe reaction to the Russian default was
markets were particularly seriously affected as interest partly due to the sizes of the losses on Russian expo-
rate spreads on their external debt increased signifi- sures and positions, but these were not in aggregate
cantly and new private external financing virtually large enough to account fully for the ensuing turbu-
ground to a halt. But the repercussions were not lim- lence. More important was the role of Russia’s default
ited to these countries, as the global flight to quality as a defining event that challenged widely held views
led to sharp increases in spreads on financial assets in about the default risks associated with all emerging
some of the deepest capital markets in the world, es- market investments, and the willingness and ability of
pecially in the United States, and to sharp volatility in the international community to provide assistance to
the dollar-yen exchange rate. countries in difficulty. That Russia had been “permit-
Subsequent actions by the Federal Reserve and ted” to default was seen by some market participants
other central banks to lower short-term interest rates as calling into question the readiness of the interna-
have helped to alleviate fears of a deepening global tional community to provide support to other countries
credit crunch, as has the international support package in difficulty. The general ensuing reevaluation of
for Brazil. However, the process of deleveraging and emerging market risk may subsequently have been
portfolio rebalancing in response to heightened risk compounded by Malaysia’s decision to impose capital
aversion may not have run its course, and the situation controls, which heightened the risk that countries in a
remains fragile, especially in the emerging markets but similar economic predicament might also impose con-
also in some of the mature markets. Moreover, follow- trols. This has so far not proved to be the case, and
ing their correction in the late summer, equity markets many emerging markets have reiterated their commit-
in a number of advanced economies have risen to lev- ment to open capital markets.
els close to previous peaks, even as the short-term A second issue concerns the sources of the vulnera-
macroeconomic outlook has weakened and uncer- bilities that led to the Russian default producing severe
tainty has further increased. liquidity problems in some of the deepest capital mar-
The global economy’s close brush with a wide- kets in the world, and prompting action by a major
spread credit crunch has raised a number of important central bank to facilitate the private rescue of a hedge
questions about international capital market dynamics fund (LTCM). The drying up of liquidity resulted
and the measures needed to improve financial sector mainly from many investors attempting at the same
resilience and reduce the risk of systemic problems, time to rapidly unwind highly leveraged positions,
including: built up either to arbitrage mature market credit
spreads or to exploit perceived differences in funding
• Why did Russia’s effective debt default in August
costs between major currencies, most notably the dol-
trigger a massive global reassessment and repric-
lar-yen carry trade.6 Modern risk management tech-
ing of emerging market risk?
niques and extensive marking to market encouraged a
• Why did the accompanying turbulence generate
very rapid rebalancing and cutting of positions judged
severe strains, sharp increases in credit and liquid-
to have become more risky. The positions that were
ity spreads, and extreme price movements in
unwound had been part of a large number of “plays”
some of the world’s deepest financial markets, in-
encouraged by—and themselves contributing to—a
cluding the U.S. market for government securities
sharp narrowing of spreads on many mature market
and the dollar-yen foreign exchange market, espe-
fixed-income instruments in the period leading up to
cially in the wake of the near-collapse of LTCM?
the Asian crisis in the second half of 1997.
• What measures can be taken to strengthen inter-
In response to the global flight to quality, spreads
national capital markets and reduce the risk of
between credits of “low” and “high” quality in several
systemic problems?
mature markets widened dramatically, especially in
The recent turbulence in global financial markets the United States, resulting in margin calls, reassess-
followed several years of sharp spread compression ments of counterpart risk, and further deleveraging.
across a wide range of debt instruments and record Several hedge funds, including LTCM, that had large
capital flows to the emerging markets. Even though positions on yields spreads were reported to have had
the Asian crisis briefly punctuated this process, the ef- difficulty meeting margin calls in the period after the
fects were felt mainly in the region, and many of the Russian default, and to be seeking additional liquidity.
mature markets benefited from a flight to quality from Hedge funds, however, were not the only participants
Asian markets. In the event, the Russian default in
August served as a trigger for a very broad-based re-
assessment and repricing of risk. This not only se- 6For further discussion, see IMF, International Capital Markets:
verely curtailed emerging markets’ access to external Developments, Prospects, and Key Policy Issues (Washington: Sep-
financing but also led to a sharp widening of interest tember 1998).

15
 I CONTAINING THE RISKS TO THE WORLD ECONOMY

in these trades and may not have been the most signif- rapid unwinding of positions without significantly
icant. While comprehensive data are not available, the affecting prices. This assumption was called into
proprietary trading desks of many of the large interna- question where many institutions held similar po-
tionally active commercial and investment banks ap- sitions. Finally, inadequate attention was paid to
pear also to have taken highly leveraged positions on the interplay between credit and market risk, such
a variety of credit spreads. In these circumstances, the as occurs in periods of extreme stress.
system was vulnerable to a sudden sharp increase in Improvements in risk modeling are required but
risk aversion, since it would trigger attempts by many will need always to be complemented by sound
financial institutions to close out their positions and judgment and strong overall risk management pro-
reduce leverage. Against this background, the Federal cedures—in order to limit excessive risk taking.
Reserve made the decision in late September to facili- • Inadequate Market Surveillance and Prudential
tate a private rescue of the troubled LTCM hedge fund Supervision by Authorities. Although weaknesses
to avoid an even more disorderly unwinding of posi- in private risk management were evident in the
tions and further financial market turbulence. period leading up to the turbulence, market sur-
Finally, the turbulence raises a number of important veillance and prudential supervision also paid in-
questions about financial market transparency, the in- sufficient attention to the buildup of highly lever-
ternal risk management and control procedures of aged positions across many institutions. Central
some of the largest internationally active financial in- banks and supervisory authorities therefore need
stitutions, and the adequacy of prudential supervision to give consideration to ways by which they can
and systemic financial market surveillance. The key monitor more adequately the degree of market-
issue is how very large leveraged positions could be wide and cross-market leverage and deal with
built up across a large number of financial institutions “excessive” leverage, through higher margin-type
to the point where systemic risk was raised to extraor- requirements, stricter capital requirements on the
dinary levels. Providing answers to these questions off-balance-sheet activities of financial institu-
and limiting future vulnerabilities is critical. tions, or both. These efforts need to be accompa-
nied by a reexamination of the adequacy of cur-
• Lack of Transparency. The failure of market par-
rent controls on the largely unregulated hedge
ticipants and financial supervisors to see warning
fund industry, including the scope either for more
signs of impending vulnerabilities appears to have
direct controls or for encouraging stronger bank
been related to a general lack of transparency
oversight of their positions vis-à-vis the funds.
about the sizes of the positions built up. The lack
Given that proprietary trading desks of the major
of transparency reflected a number of factors in-
banks are increasingly engaged in activities simi-
cluding the opaque nature of the over-the-counter
lar to those of many hedge funds, the focus will
markets in which much of the off-balance-sheet
need to be on ensuring appropriate oversight and
trading takes place, the difficulties in assessing
control of these highly leveraged activities so as
complex positions in layers of highly structured
to contain risks to individual institutions as well
off-balance-sheet financial instruments, and the
as systemic risk.
desire of the institutions involved to maintain se-
crecy to exploit profit opportunities. There are un- The issues raised by the most recent financial mar-
likely to be easy solutions to improving trans- ket turbulence are complex, including the adequacy of
parency in over-the-counter markets, but the private and public risk management in some of the
recent turbulence suggests a need to strengthen most sophisticated financial institutions in the world,
position reporting to at least allow for the better the growing linkages between emerging and mature fi-
monitoring by authorities of overall exposures. nancial markets, and the role of leverage in magnify-
• Financial Firms’ Risk Management Models Dis- ing the system’s vulnerability to shocks. Against this
played Weaknesses. Internal risk management background, current bilateral and multilateral initia-
models are intended to identify and limit the mar- tives to consider the adequacy of current prudential
ket risks assumed by financial institutions. At least controls over financial institutions—especially the
in hindsight, the models used by some of the major highly leveraged activities—and to revisit the treat-
financial institutions did not provide adequate ment of credit and market risk under the Basle capital
safeguards. The recent episode of turbulence sug- adequacy ratios are critically important. These will
gests at least three problems. First, insufficient at- need also to be complemented by stepped-up efforts to
tention was paid to low-probability events, per- improve the transparency of financial institutions’ off-
haps as a result of inadequate stress testing and the balance-sheet activities with a view to lessening the
belief that financial markets would continue their risks of the kind of large buildup of highly leveraged
long rally. Second, the models typically assumed positions that contributed to the severity of the recent
that market liquidity would be present to allow a problems in mature financial markets.

16