KROON&ECONOMY

INTERNATIONAL MONETARY FUND AND ECONOMIC POLICY SURVEILLANCE Reet Reedik

Why Does the IMF Monitor Economic Development of the World and Individual Countries? In today’s globalising world, the economic development and economic policy decisions of individual countries often have a direct or indirect impact on several others. Due to the reduction of the limitations on the free movement of capital, technological advances and growth of private capital flows’ crises can spread extremely quickly from one country into another. In 1997–1998 financial crises in Asia The International and Russia rocked the world’s financial markets. To a greater Monetary Fund or lesser extent these shocks affected all the countries of (IMF) is the the world: investments dwindled, financing conditions institution that worsened and foreign trade shrank. Crisis prevention and resolution of existing crises requires international cohas dealt with operation in the field of economic policy, unbiased evaluation securing of the of the situation and financial aid, if necessary.

stability of the

international The International Monetary Fund (IMF) with its 184 member countries – including Estonia – is the institution monetary system that has dealt with securing of the stability of the since the international monetary system since the mid-1940s, thanks mid-1940s. to the peculiarities of its management structures and ways of raising financial resources, as well as experts with vast experience. The goals of the IMF have, of course, changed somewhat over the years. Until the beginning of the 1970s, the aim was the preservation of the international gold standard. At the moment, maintaining of the mutual stability of the exchange rates is not an aim in itself, however, sustainable and stable economic growth and prevention of financial crises are still among the IMF priorities. The goal of the IMF surveillance activity is to encourage countries to apply economic policies and institutional reforms that would support the sustainable and balanced development of the world economy, strengthen the resilience of each country to external shocks and, thus, help to prevent the emergence and spread of financial crises.

Main Forms of Surveillance •

Multilateral surveillance Twice a year the IMF assesses developments of the world economy and publishes its forecasts in World Economic Outlook. This publication also forms a basis for the biannual

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No 1, 2002 (spring and autumn) meetings of the IMF’s Monetary and Financial Committee, as well as the economic policy discussions of the member countries that take place in the framework of the IMF’s annual meeting. The most recent changes in multilateral surveillance concern the monitoring of international capital flows, the analysis of which had so far been relatively weak and focused mostly on the problems of emerging markets. Since 2002, the IMF publishes the quarterly Global Financial Stability Report that covers both developed and emerging capital markets. These evaluations on the world economy and the functioning of financial markets are used more and more for assessing the vulnerability of individual countries and as background information in bilateral consultations. •

Bilateral surveillance As a rule, bilateral surveillance is carried out in the framework of economic policy consultations with member countries that take place once a year. It is called Article IV Consultations, which derives from Article IV of the IMF’s Articles of Agreement that states the general obligations of the IMF and its member countries in securing the stability of the international monetary system. The consultations focus on the exchange rate, fiscal and monetary policy, the balance of payments and external debt problems and evaluation of the impact of economic policy steps on external balance and on other countries, as well as analysing the vulnerability of member countries to external influences.

Article IV of the IMF’s Articles of Agreement

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Section 1. General obligations of members Recognizing that the essential purpose of the international monetary system is to provide a framework that facilitates the exchange of goods, services, and capital among countries, and that sustains sound economic growth, and that a principal objective is the continuing development of the orderly underlying conditions that are necessary for financial and economic stability, each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. In particular, each member shall: endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances; seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions; avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members; and follow exchange policies compatible with the undertakings under this Section.

KROON&ECONOMY

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Section 3. Surveillance over exchange arrangements The Fund shall oversee the international monetary system in order to ensure its effective operation, and shall oversee the compliance of each member with its obligations under Section 1 of this Article. The Fund shall exercise firm surveillance over the exchange rate policies of members, and shall adopt specific principles for the guidance of all members with respect to those policies. Each member shall provide the Fund with the information necessary for such surveillance, and, when requested by the Fund, shall consult with it on the member’s exchange rate policies.

The fact that the sections of Article IV mainly refer to the exchange rate can be explained by the historical role of the IMF in preserving the gold-based international monetary system. Today, this article is interpreted somewhat wider – from the aspect of maintaining the stability of the international financial system. At the end of the consultations, IMF experts prepare a report on the economic situation of a country and discussions and submit this to the IMF’s Executive Board consisting mostly from representatives of member countries. Here we can see the co-operative nature of the IMF evaluations. Estonia, too, can express its opinion of the economic policies of other countries through the director of the Nordic-Baltic constituency. The common assessment of the Board is published together with the IMF press release on the conclusion of Article IV consultations. Article IV missions are not the only method of bilateral consultations. In the case of mutual interest shorter visits are arranged in order to discuss some concrete problem, first of all in the sphere of fiscal and monetary policy.

Improvement of Surveillance The modern day balance of payments crises entail considerably larger financing needs than the trade balance problems of the past. The role of the financial sector in mediating capital flows has also become more important. Resolution of the crises is costly and therefore investments must, first and foremost, be aimed at preventing them. Thus, the IMF has devoted more and more attention to improving the surveillance methods and developing the self-discipline of member countries. In the agendas of recent years preference has been given to the analysis of the financial sectors and evaluation of their shock resistance, implementation of international standards and codes of good practices in the monetary and financial sector and transparency of economic policy. •

Greater transparency Let us recall that even at the end of the 1990s all IMF reports on member countries and economic policy memorandums accompanying loan agreements were mostly kept in great secret. This was due to the respective agreements between the member countries.

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No 1, 2002 However, since 1999 the IMF has put great emphasis on publishing the above-mentioned reports and memorandums. For the member countries disclosure is still voluntary, though. •

Higher quality data Timely, reliable and understandable statistical data is extremely important in both implementing economic policy and making investment decisions. In addition to compiling various statistical publications1 on the member countries, the IMF also unifies statistical standards. The aim of the Special Data Dissemination Standard (SDDS), worked out by the IMF in 1996 and constantly improved in later years, is to provide the public with timely and reliable data on the real, fiscal, financial and external sectors.

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Evaluation of the strength of the financial system Often it is the financial system of the country that passes on financial crises into the rest of the economy and, vice versa, a sufficiently strong financial system can soften the shocks that have hit the real sector. The aim is to increase the quality of the financial system analysis in order to estimate the risks in a more reliable way and prevent crisis situations. In response to the crises of recent years new early warning indicators are being worked out which would point to the emergence of problems2. Special attention is devoted to the countries’ external debt (both state and private sector debt) and foreign currency reserves, but also other macroeconomic indicators, which could reveal unfavourable developments. In order to improve the stability of the world financial system the IMF and the World Bank initiated a joint financial sector assessment programme in 1999, in the course of which the stability and strength of the member countries’ banking and financial system is assessed, as well as the correspondence of regulative acts and supervision to international standards, shock resistance of the banking and financial system, etc.

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Standards and codes One of the main conclusions drawn from the financial crises of Asia and Russia was the need to provide financial markets with timely and clear information on the economic situation and policy principles of a country. Openness and understandability helps the private sector – both companies and private individuals – to better estimate the economic and financial situation of the country. This makes the behaviour of investors more stable and reduces the danger of sudden financial crises. In the past three years, the adoption of international standards and codes has spread widely in the world economy. In cooperation with other international organisations the IMF has defined a dozen standards, which are vital from the point of economic policy transparency and efficiency of the financial sector supervision and the implementation of which the IMF monitors in the member countries. By their contents, standards and codes can be divided into three groups: transparency, financial sector regulation and supervision and market regulation.

1 International Financial Statistics, Balance of Payments Statistics Yearbook, Government Finance Statistics Yearbook, Direction of Trade Statistics. 2 See for example the surveys on early warning models (Global Financial Stability Report, IMF, April 2002, pp 48–64) and the early warning indicators of the financial sector (Macro-prudential Indicators of Financial System Soundness, Occasional Paper No 192, IMF, 2002).

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KROON&ECONOMY The transparency standards comprise statistical standards and codes of good practices on the transparency of fiscal, monetary and financial sector policies – understandability of the policy and transparency of its formation, accountability of the state authorities and responsibility for implementing the policy. The financial sector regulation and supervision standards include first of all the standards of the banking, insurance and securities market supervision, plus the requirements set on payment systems. In 2002, the principles of fighting money laundering and financing of terrorism were added to the list of standards. The market regulation standards look at the degree to which the government guarantees property rights. The standards included in this group focus on the legal status of investors, disclosure requirements and insolvency regulation. This group also contains the bookkeeping and auditing standards since effective protection of investor rights would be impossible without the observance of them. The standards and codes on transparency have mostly been worked out by the Fund itself while the supervision standards have been elaborated by other international organisations. With the consent of the member countries the IMF also draws up reports on their observance of the standards and codes (ROSC – Reports on Observance of Standards and Codes).

What Is the Difference between Surveillance and Review of Economic Programme? When a member country borrows from the IMF it also has to adopt an economic policy programme (Memorandum on Economic Policies; MEP). The programme contains certain quantitative performance criteria on economic indicators (usually concerning the budget deficit, government sector debt, foreign currency reserves, etc) and structural reforms. Adherence to these criteria grants the borrower periodical release of loan disbursements and gives the IMF confidence that its resources are safe. The observance of the programme is monitored more frequently than the usual surveillance of the economy. For the sake of saving resources, the Article IV consultations and economic programme reviews are often carried out simultaneously. Thus, it could happen that the Article IV mission evaluates the economic situation of a country from the point of adherence to the policy programme and the necessary ‘bystander’ assessment is not carried out. It is claimed that the potential risks of the short and medium term tend to be overlooked in the course of Article IV consultations in the borrower countries. In essence, surveillance and economic policy review are two different procedures and therefore the Fund is currently elaborating more precise instructions for conducting Article IV consultations in borrower countries.

Estonia’s Economic Policy Consultations with the IMF Estonia gave up the borrower country status in the autumn of 2001 when the last 18-month Stand-by Arrangement expired. Actually, Estonia has not used IMF loans since 1995. Still,

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No 1, 2002 the stand-by facility has been there for us as a safety net during our economic reforms and in case of serious balance of payments problems we could have used it. The economic policy consultations held in April 2002 were practically the first that concerned only Article IV obligations and meant a qualitatively new level for Estonia as a member of the IMF. This can also be seen from the report3 which, unlike in previous years, focuses more on the medium The economic and long-term economic growth and economic policy policy consultations aspects (cyclically balanced fiscal policy, productivity comparison with the EU and other candidate countries held in April 2002 and the resulting effect on potential economic growth). meant a And of course the IMF continues to give its traditional qualitatively new recommendations on the external balance and fiscal level for Estonia as policy over a shorter period.

a member of the IMF.

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Estonia has participated in practically all the abovementioned pilot projects of the IMF aimed at deepening surveillance and greater transparency: Since 1999, reports of Article IV consultations with Estonia and the economic policy memorandums and interim reviews have been available to Estonian as well as international public; In 1998 Estonia became a subscriber to the IMF’s Special Data Dissemination Standard (SDDS)4; In 2000 Estonia participated in the IMF-World Bank joint Financial Sector Assessment Programme; In the framework of the financial sector assessment programme the IMF in 2000 also assessed the transparency of monetary and financial sector policies and standards of the financial sector supervision. In 2001 the Fund assessed Estonia’s fiscal transparency as well as the availability and quality of statistical data. In July 2002 a survey of Estonia’s progress in the implementation of the above standards since the preparation of the first review reports was published as an appendix to the Article IV consultations report.

It is difficult to give an objective evaluation of the quality and impact of the IMF’s economic policy recommendations in Estonia, since the country has no record of previous stable market economy period against which to compare the present developments. Also, we have to keep in mind that the economic policy programmes (MEPs) accompanying the IMF loans are, first and foremost, reform programmes drawn up by the country’s own authorities, even when the Fund’s recommendations and certain requirements are followed. Therefore, the responsibility for the implementation of the policy recommendation lies with the country itself. Undoubtedly, the IMF has been of great support for Estonia in carrying out a number of politically complicated reforms.

3 The IMF press releases, report on consultations and progress in implementing international standards and codes of practices, as well as the Estonian statement made at the IMF Executive Board meeting can be found at the IMF Web site at http://www.imf.org/external/country/EST/index.htm. Translations into Estonian are available at the home page of Eesti Pank at http://www.ee/epbe 4 For further explanations and the data Estonia provides in the SDDS framework see Eesti Pank’s Web site at http:// www.ee/epbe/en/sdds.html

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KROON&ECONOMY As far as the surveillance activity and its new forms are concerned, Estonia has benefited from those in many ways: • Higher requirements on transparency and The economic policy observance of standards and codes of good programmes (MEPs) practices increase the responsibility of state accompanying the authorities and demand better reasoning for IMF loans are policies applied in various spheres; • Assessments of foreign experts on Estonia’s foremost reform economic situation leads to more active and better programmes drawn argumented economic policy discussions within up by the country’s the country; own authorities. • Publication of Article IV reports and assessments on the observance of internationally acknowledged standards has had a positive effect on Estonia’s image in the eyes of foreign investors and rating agencies. For small countries this is a very important aspect of improving the country’s reliability.

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