After a year of negotiations, the IMF approved a $6.6 billiondebt rollover for Argentina on January 24, giving the coun-

try breathing room to maintain stability ahead of presidentialelections scheduled for April. The agreement also clears the wayfor the multilateral development banks to resume their supportof social programs, following Argentina’s recent clearance ofarrears to them.

The pact includes an eight-month loan of about $2.9 billion,enough to cover all of Argentina’s payment obligations to theIMF through August 2003. A first disbursement of $1 billionwas made on January 28. The IMF also agreed to extend forone year another $3.7 billion of payments to the IMF expectedthrough August. IMF Managing Director Horst Köhler said the“transitional program is viewed as a step to

InternationalMonetary FundVOLUME 32NUMBER 2February 3, 2003

In this issue

17Singh on crises in Latin America

17Debt rolloverapproved forArgentina

22Leiderman oninflation targeting

24AEA meeting

26Taylor on monetary policy

28Clark and Polak on SDRs

31Challenges ofEU enlargement

and…

20Selected IMF rates

21Recent publications

27New on the web

17

New IMF loan

Argentina promises financial disciplineand greater legal certainty

Anoop Singh, a national of India, took charge ofthe IMF’s Western Hemisphere Department in

September 2002. Before that, he was Director for SpecialOperations—a unit formed in 2002 to bring together theIMF’s expertise in resolving financial crises. In both posi-tions, he has drawn on his over 25 years of experience atthe IMF—as Deputy Director of the departments coveringthe Asia-Pacific region in the mid- to late 1990s, includingduring the Asian financial crisis and its aftermath. In theearly 1980s, he served as Special Advisor to the Governorof the Reserve Bank of India. Laura Wallace spoke withSingh about the challenges the department faces, especiallyin the IMF’s efforts to end the financial crises in LatinAmerica and rebuild growth.

IMF SURVEY: What are the main lessons the IMFshould draw from Argentina’s collapse in 2001–02 andearlier IMF financial support for the country’s policies? SINGH: There are many lessons—for policies and forour own surveillance role—and we are still assessing

them. But some are already clear. Argentina’s exchangerate arrangement, which was a very hard currency peg(a currency board), worked well in the early years toanchor inflation

(Please turn to page 21)

(Please turn to the following page)

www.imf.org/imfsurvey

Interview with Anoop Singh

Latin America must tackle social ills and increasegrowth while keeping economies stable

Singh: “The safe level of debt for many emerging marketcountries is almost certainly much lower than earlierperceptions.”

Argentina’s new program includes higherspending for social safety nets to protect themost vulnerable segments of the population.

February 3, 2003

18

reduction. However,during the 1990s, key parts of the macroeconomic pol-icy framework, as well as structural policies, becameincreasingly inconsistent with sustaining the currencyboard—in particular, the rising level of federal andprovincial debt. One clear lesson for other countries isthat high public debt increases vulnerability, especiallyif there is a high degree of dollarization. The safe levelof debt for many emerging market countries is almostcertainly much lower than earlier perceptions.

IMF SURVEY: Where do we go from here, and how doyou assess the January debt rollover agreement?SINGH: All the parties involved have been trying forat least a year to develop a strong policy frameworkthat will allow Argentina to recover from the crisisand rebuild a basis for growth. This has taken muchlonger than anybody expected—partly because thecrisis is very deep and partly because it is difficult, inthe middle of such a deep crisis, to get the consensusneeded across the community to carry forward astrong recovery program. The government has for-mulated a transitional program as a step toward amore comprehensive program that could be devel-oped soon after a new government assumes office inlate May. The hope is that this program will helpmaintain macroeconomic stability during the politi-cal transition, thereby helping bridge the period untila more comprehensive program can be developed bythe successor government.

IMF SURVEY: There’s a lot of criticism in the pressthat the motivations for this were a bit suspect.Was the IMF simply responding to pressure from itsmajor shareholders or trying to avoid IMF arrears? SINGH: As I said, we have all searched for a comprehen-sive program that would give strong assurances notonly about immediate macroeconomic policies andtheir implementation but also about economic restruc-turing—of the banking system, fiscal relations with theprovinces, tax reforms, and debt, to name a few. All thiscould not be achieved at this time, but we hope that thetransitional program will be a bridge to that compre-hensive program. I don’t think it is very productive tospeculate about motives. All parties have shared thesame objective for Argentina—a full and durablerecovery—and the IMF is committed to making thetransitional program work.

IMF SURVEY: Why does Latin America seem to havebenefited so little from the policy improvements thatthe IMF has been hailing since the 1980s?

SINGH: Much was achieved in the 1990s, especially inreducing inflation, and I think we should resist lookingat the region as a whole, even though there are manycommon elements. Several countries were able tostrengthen their policy frameworks and maintaingrowth, whereas others proved more susceptible torecurrent crises. Those in the former group emphasizedfiscal strength and institutional reform, while othercountries remained crisis prone because of inconsisten-cies in the policy framework. High or growing dollariza-tion—of banking systems and debt—was another keyfactor. In many countries, the benefits of reform andgrowth were not broadly shared, labor reform remaineda problem, and the targeting of social spending did notimprove sufficiently—this meant that income inequali-ties remained high or that previous gains began to bequickly reversed as growth faltered later in the 1990s.

One lesson that the IMF has learned is that, in ourown policy advice, we need to pay even more atten-tion to sustainability. We must also coordinate betterwith the World Bank and the Inter-AmericanDevelopment Bank so that, together, we look acrossmacroeconomic, structural, and institutional policies.Political coherence and consensus are, of course, alsoessential, and often these have tended to overshadowthe economic factors.

IMF SURVEY: Is the worst finally over in Latin America?SINGH: There are some positive events and trends in anumber of countries. But the international environ-ment remains difficult for the region, and manycountries must still adequately address significantweaknesses and vulnerabilities.

On the positive side, take Brazil, which has completeda complex political transition in an exemplary fashionthat must clearly rank as a model for others. Marketshave welcomed this, and risk indicators have improved.We have established an early dialogue with the new eco-nomic team—which is preserving economic policy con-tinuity even as it prepares to address social and incomeinequities––and the IMF’s Managing Director and I hadour second meeting with President Lula da Silva a fewdays ago. I would like to believe that the IMF has playeda supportive role in Brazil’s transition. A few monthsbefore the elections, the IMF approved a new loanthrough 2003 in support of a program whose core ele-ments were endorsed by the major presidential candi-dates. Since the new government has taken office, it hasbegun to follow through with announcements and poli-cies that are consistent with the program. And, as mar-kets have realized in the last few weeks that economiccontinuity is being assured and that the new president

Singh on Latin America (Continued from front page, top)

One lesson thatthe IMF haslearned is that,in our ownpolicy advice,we need to payeven moreattention tosustainability.

—Anoop Singh

February 3, 2003

19

aims to do this with a much stronger emphasis on socialequity—an emphasis with which we completely agree—many market indicators have improved considerably.Brazil is not the only example, of course.

IMF SURVEY: Is Brazil’s transition model one thatArgentina might want to emulate?SINGH: Each case is, of course, different. Argentina nowhas a program for its period of political transition,with the expectation that the successor governmentwill quickly develop its own program. Nevertheless,there are important aspects of Brazil’s transition thatshould be highlighted—especially, how the presiden-tial candidates came together to emphasize the broadconsensus in the community for core economic goals.Another example is that of Korea in late 1997, whenthe incoming government endorsed the key policies inthe economic program that was being put together inrecord time.

IMF SURVEY: What are the other promising signs inLatin America?SINGH: Certainly, Colombia. The government hasbeen successfully steering strong economic policiesthrough congress—recently securing support forsome difficult fiscal measures, tax reforms, pensionreforms, and labor market reforms. This was a majorlandmark. In the past month, Colombia has regainedmarket access, showing that markets differentiateand respond to good policies. Granted, Colombiafaces very difficult problems—economic ones as wellas the problems from the civil conflict. But we see agovernment prepared to make difficult economicdecisions, which is why the IMF Board agreed inmid-January to a new loan. Let me also mentionPeru, which has managed to maintain relatively highgrowth in a difficult external environment while car-rying forward essential economic reforms. We arealso encouraged by the early steps taken by Ecuador’snew government.

IMF SURVEY: So the worst is over.SINGH: That’s difficult to say. Many countries remainvulnerable because of high debt, dollarization, lowgrowth, and high income inequalities. The externalsituation also remains difficult, with many downsiderisks. There is no doubt that countries everywhereneed to persevere with economic reforms, extendingthese to strengthening institutions, but this requires aconsensus across the community—which is tough tosecure in an environment of low growth and highinequality. Even so, markets can be expected torespond positively to countries that are able to carryout these changes.

IMF SURVEY: To what extent are LatinAmerica’s fortunes tied up with those ofthe United States?SINGH: The importance of the UnitedStates can be demonstrated in at least twoways. First, there is the trade link. TakeMexico, in which the North AmericanFree Trade Agreement has helped increaseU.S.-Mexican trade to almost half ofMexico’s GDP from around one-fourthbefore the pact. For other Latin Americancountries, the trade link is less important,but the United States still accounts foralmost a third of their total trade. Second,there is the financial link. A significantproportion of capital flows into LatinAmerica come from the United States.And, given that Latin America has tendedto depend heavily on portfolio inflows, U.S. interestrate changes have a major effect on Latin Americaninterest rates. Plus, don’t forget the important rolethat the U.S. economy played in the 1997–98 Asiancrisis—it helped accelerate an export-led recovery forthe Asian economies and insulate Latin America fromsome of the worst effects of the crisis.

IMF SURVEY: What more can be done to enhance LatinAmerica’s trade prospects? Any insights from Asia?SINGH: Latin America’s share of trade in its GDP isgenerally much lower than in many Asian countries,giving rise to considerable imbalance between itstrade openness and its capital market integration.Typically, Latin American countries have been muchmore open on their capital account than on theirtrade account, making it difficult for real deprecia-tions to result in export-led recoveries out of financialcrises. How can trade openness be increased? ManyLatin American countries are still quite protectionist.But the industrial countries, also, need to ensure bet-ter market access, along with maintaining robustglobal growth. We are giving increasing attention tothese issues as we look at Latin America’s medium-term growth prospects.

IMF SURVEY: With a variety of economic plans beingfloated, do you have any words of caution for the U.S.administration?SINGH: As we prepare for the annual consultationwith the United States in May, I would just note thatwe’ll be assessing current initiatives against keythemes raised in last year’s consultation—includingpreparing for the fiscal and other challenges expectedto arise from population aging and aiming to balancethe budget (excluding social security) over the cycle.

Singh: “As far as ourrelationships withcountries areconcerned, we mustreach out to broadersections of thecommunity.”

February 3, 2003

20

IMF SURVEY: What lessons did you learn in dealingwith the Asian crises that you’re trying to use indealing with Latin America?SINGH: Although every crisis is different—this is animportant lesson in itself—the Asian crisis under-scored the links between the financial and corporatesectors and the external situation. We now have abetter understanding of how capital account crisesdevelop, the need to maintain financial sector sound-ness, and the need to act decisively with insolven-cies—to have in place efficient mechanisms to dealwith nonperforming loans and facilitate corporaterestructurings. Alternatives are needed to resolve cor-porate insolvencies—the court process would taketoo long—hence the importance of developing out-of-court restructuring procedures with balancedincentives for creditors and debtors. There is alsonow a better understanding of the need to ensureconsistency and coherence between different partsof the policy framework. So, if a country has a fixedexchange rate, it has to adopt economic policies thatare consistent with this kind of arrangement.

IMF SURVEY: Is it feasible for Latin America to putmore energy into attacking poverty and incomeinequality while it’s trying to sort out its finances?SINGH: It isn’t a question of whether it’s feasible.It needs to be done. It isn’t possible to have eco-nomic sustainability without social sustainability.The challenge is to tackle social inequities whilemaintaining macroeconomic stability. Many coun-tries have budgetary revenue and expenditurerigidities that, if unlocked, would allow a bettertargeting of social spending. Let’s take Brazil—whose tax ratio exceeds 30 percent of GDP.However, a large proportion of revenue is ear-marked for certain uses, leaving little room for dis-cretionary outlays. In other countries, where tax

ratios are low, raising social spending does entailraising revenues, but again this can be done tosome extent by eliminating exemptions and con-cessions. It does not always mean higher tax rates,but it does mean building a culture of tax compli-ance, which is difficult.

IMF SURVEY: Are you hopeful?SINGH: Yes, I am, but I’m aware that it will requirea strong consensus in many countries to overcomevested interests and take all the steps that are neededto build fiscal sustainability and growth. This isn’t easyto do, especially in an environment of weak growth.

IMF SURVEY: What are your plans for the WesternHemisphere Department? Should we expect anychanges in the way the IMF works with countries inthe region?SINGH: It’s only been a few months, but many chal-lenges are clear. We held an early retreat with staffand have set certain principles for good manage-ment. Even so, the risk remains of getting excessivelypreoccupied with some countries that demandimmediate attention—and we have been trying tomaintain an even balance across the department.We are also looking to build research capacity andlearn lessons from the recent experience in LatinAmerica. We have begun work on a paper, whichshould be done in the first half of this year, that willassess the current situation, draw lessons from the1990s, and develop proposals for improving ourpolicy advice. We are also planning to hold a confer-ence on Latin America this spring.

As far as our relationships with countries are con-cerned, we must reach out to broader sections of thecommunity. In my initial visits to Argentina, we madea major effort in this direction—we met with provin-cial leaders and administrators, trade union leaders,bankers, representatives of the church, and others.I think this effort was extremely helpful in enabling usto more fully understand the depth and complexity ofthe Argentine crisis. Obviously, we can’t make thiskind of effort in every country, but we would like to.

IMF SURVEY: You’re the first head of WesternHemisphere not to speak Spanish. Is that provingto be a major hurdle?SINGH: I’m trying to change this but it will not hap-pen overnight, and it’s actually proving to be muchless of a hurdle than I had feared. English is spokenextremely well across Latin America, and everyone Ihave met has been very understanding about myobvious lack of Spanish. And when it’s necessary,IMF translators provide excellent support.

Selected IMF ratesWeek SDR interest Rate of Rate of

beginning rate remuneration charge

January 20 1.89 1.89 2.42January 27 1.88 1.88 2.41

The SDR interest rate and the rate of remuneration are equal to aweighted average of interest rates on specified short-term domesticobligations in the money markets of the five countries whose cur-rencies constitute the SDR valuation basket. The rate of remunera-tion is the rate of return on members’ remunerated reserve tranchepositions. The rate of charge, a proportion of the SDR interest rate,is the cost of using the IMF’s financial resources. All three rates arecomputed each Friday for the following week. The basic rates ofremuneration and charge are further adjusted to reflect burden-sharing arrangements. For the latest rates, call (202) 623-7171 orcheck the IMF website (www.imf.org/cgi-shl/bur.pl?2001).

General information on IMF finances, including rates, may be accessedat www.imf.org/external/fin.htm.

Data: IMF Treasurer’s Department

Manycountriesremainvulnerablebecause ofhigh debt,dollarization,low growth,and highincomeinequalities.

—Anoop Singh

February 3, 2003

21

Recent publications

IMF Working Papers ($15.00)02/211: An Evaluation of Monetary Regime Options for

Latin America, Andrew Berg, Eduardo Borensztein,and Paolo Mauro

02/212: A Political-Economic Model of the Choice ofExchange Rate Regime, Yan Sun

02/213: The Persistence of Corruption and SlowEconomic Growth, Paolo Mauro

02/214: WTO Financial Services Commitments:Determinants and Impact on Financial Stability,Nico Valckx

02/215: Implications of Migration on Income andWelfare of Nationals, Kenichi Ueda

02/216: Population Aging and Long-Term FiscalSustainability in Austria, Leif Lybecker Eskesen

02/217: International Liquidity and the Role of the SDR in the International Monetary System,Peter B. Clark and Jacques J. Polak

02/218: Financial Contagion and Investor “Learning”:An Empirical Investigation, Ritu Basu

02/219: Welfare Effects of Transparency in ForeignExchange Markets: The Role of Hedging Oppor-tunities, Burkhard Drees and Bernhard Eckwert

02/220: Monetary Policy Credibility and theUnemployment-Inflation Trade-Off: Some Evidencefrom 17 Industrial Countries, Douglas M. Laxton and Papa N’Diaye

IMF Staff Country Reports ($15.00)03/01: Tanzania: 2002 Article IV Consultation,

Fifth Review Under the PRGF, and Request foran Extension of the Arrangement and Waiver ofPerformance Criterion

03/02: Tanzania: Selected Issues and Statistical Appendix 03/04: Bosnia and Herzegovina: First Review Under

the Stand-By Arrangement and Request forWaiver of Performance Criteria

03/05: Republic of Tajikistan: Selected Issues andStatistical Appendix

03/06: Madagascar: 2002 Article IV Consultation,Second Review Under the PRGF, and Requests forExtension of Arrangement, Waiver of PerformanceCriteria, and Additional Interim Assistance Underthe Enhanced HIPC Initiative

Economic issues (free)Rural Poverty in Developing Countries: Implications for Public

Policy, Mahmood H. Khan (No. 26) The Pension Puzzle: Prerequisites and Policy Choices in

Pension Design, Nicholas Barr (No. 29) Hiding in the Shadows: The Growth of the Underground

Economy, Friedrich Schneider and Dominik Enste(No. 30)

Other publicationsGovernment Finance Statistics Yearbook 2002 ($80.00)

Publications are available from IMF Publication Services, Box X2003, IMF, Washington, DC 20431 U.S.A.Telephone: (202) 623-7430; fax: (202) 623-7201; e-mail: publications@imf.org.

For information on the IMF on the Internet—including the full texts of the English edition of the IMF Survey, the IMF Survey’sannual Supplement on the IMF, Finance & Development, an updated IMF Publications Catalog, and daily SDR exchange rates of45 currencies—please visit the IMF’s website (www.imf.org). The full texts of all Working Papers and Policy Discussion Papers arealso available on the IMF’s website.

a comprehensivemedium-term program, which is needed to reestab-lish investor confidence and capital inflows, achievefiscal and external viability, and establish sustainablegrowth in Argentina.”

The transitional program focuses on maintainingmonetary and fiscal discipline, avoiding policyreversals, and rebuilding legal certainty, the IMFsaid. The monetary program aims to limit thegrowth of the monetary base to anchor inflationexpectations, while the fiscal program calls for firmcontrol over primary expenditures at the federaland provincial levels. Argentina has promised toraise the primary budget surplus target—an indica-tor of the government’s capacity to pay debt obliga-tions—to 2.5 percent of GDP for 2003, up from 0.7percent in 2002. The primary surplus for provincialgovernments should be about 0.4 percent of GDP

in 2003 compared with a deficit of 0.5 percent in2002.

The IMF said the Argentine authorities intendedto work closely with the congress to secure approval ofthe revenue measures needed to meet the fiscal targets.The program provides for a doubling of outlays on asocial safety net—from 0.6 percent of GDP in 2001 to1.2 percent of GDP in 2003. To prepare the ground forthe successor government expected in May, the author-ities will formulate the needed fiscal structural reformsto broaden the tax base, improve tax administration,and reform intergovernmental relations.

The transitional program assumes real GDPgrowth of about 2–3 percent for 2003, comparedwith an estimated decline of 11 percent in 2002;inflation being held within 35 percent; a currentaccount surplus of about $6.5 billion; and broadlyunchanged gross international reserves.

Argentina gains breathing room(Continued from front page, bottom)

February 3, 2003

22

Nearly 20 countries around theglobe have officially adopted

inflation targeting, a framework formonetary policy based on a specifictarget (or target range) for infla-tion. On December 19, 2002,Leonardo Leiderman of Tel AvivUniversity presented a seminar atthe IMF Institute on the challengesfaced by emerging market econ-omies with inflation targeting. Heconcluded that, despite these chal-lenges, inflation targeting had,overall, produced satisfactoryresults for these countries.

Inflation targeting is no longerconfined largely to industrial

countries but has been embraced by many emergingmarket and developing countries (see table, thispage). But for emerging market economies,Leiderman said, implementation is more of a chal-lenge than for industrial countries for a couple ofreasons. First, emerging market economies appearmore susceptible to shocks that can make attainmentof the target a challenge. For instance, exchange ratesin these countries are generally more volatile than inindustrial countries, and an unexpected and sharpdepreciation of thedomestic currency canmake it difficult for thecentral bank to meetpreviously announcedtargets.

Indeed, in a number ofemerging market econ-omies, inflation rates lastyear were outside theannounced target range.How countries respond tothis divergence betweenplan and outcomes,Leiderman said, may becritical in determining theeventual success of infla-tion targeting as a mone-tary regime.

Second, the success ofinflation targeting—as

with any monetary regime—requires that “all mem-bers of the orchestra play together.” This means thatthe country’s treasury and central bank have to agreeon the inflation target and the policy settings thatwill achieve it. Pressure from the treasury to makethe central bank finance a large part of the budget(through the printing of money) can undermine thesuccess of any monetary regime. The experiences ofemerging market economies suggest that the adop-tion of inflation targeting does not automaticallyinsulate the central bank from such pressures. Wage-setting institutions also have to be supportive of thecentral bank’s inflation targets.

A testing timeLeiderman noted that inflation forecasts for a num-ber of emerging market countries—among themBrazil, Colombia, Israel, and Mexico—were currentlyoutside the announced target ranges. For instance,the Brazilian central bank had originally targetedinflation for 2003 of 4 percent, plus or minus 2.5 per-cent. But private sector expectations for inflation in2003 are currently about 11 percent, reflecting therun-up in inflation as a result of the sharp deprecia-tion of the peso last year and an increase in fuelprices.

How will the central banks of these countries dealwith this situation? On the one hand, they must take

IMF Institute Seminar by Leiderman

Inflation targeting in emerging markets:Easier said than done

Leiderman: “The success of inflationtargeting—as withany monetaryregime—requiresthat ‘all members ofthe orchestra playtogether.’ ”

More emerging market economies are adopting inflation targeting (classification by exchange rate regime)

Managed floating Pegged exchange rates Exchange rates within with no preannounced

Independently floating within horizontal bands crawling bands path for exchange rate

Australia Hungary Israel ThailandBrazil

CanadaChile

ColombiaCzech Republic

IcelandKorea

MexicoNew Zealand

NorwayPoland

South AfricaSweden

United Kingdom

Source: IMF, International Finance Statistics, January 2003. Classification is as of end-2001.

February 3, 2003

23

these deviations seriously if they are to maintain the credibility of the regime. On the other hand,Leiderman said, they most likely also want to avoid being thought of as “inflation nutters”—policymakers who are oblivious to the short-termeffects on output and employment of rigid adherenceto inflation targets. Leiderman noted that this tensionbetween wanting a “hard target” to gain or maintaincredibility versus wanting a “soft target” to allow flexi-ble responses to unforeseen developments in theeconomy had been present since the inception ofinflation targeting. In the early days, hard targets werepreferred, but sentiment appears to be veering towardthe soft target approach.

Try a little tendernessLeiderman reckoned that, among the emerging mar-ket economies, “more and more countries will moveto the Australian model” of soft inflation targeting,under which the central bank seeks to adhere to aninflation target “on average over the course of thecycle” or “as a medium-term objective.”

This would not be a bad thing, he said. Theexperiences of countries that had been on inflationtargeting regimes for a number of years suggestedthat the public cared about the central bank’s aver-age performance over the period rather than itsperformance in any one year. For instance, henoted that Israel’s central bank had missed itsinflation target in 9 of 11 years. But, because thedeviations were small, the average performance ofinflation over the whole period was pretty close tothe average of the target ranges, and the inflationtargeting regime had enjoyed credibility and publicsupport (see table above).

(Since Leiderman’s seminar, the Brazilian centralbank has announced that it will now target an infla-tion rate of 8.5 percent for 2003 and 5.5 percent for2004. The new target for 2003 is more than doubleits original target but still below private sector fore-casts for the year. In a letter to the finance ministry,the central bank noted that “monetary policy willbe able to make inflation converge with the ceiling

of the (original) goals in twoyears.”)

It’s mostly fiscalWhile generally supporting a moveby emerging market economies toan Australian model of inflationtargeting, Leiderman also soundeda note of caution. There is a “dangerthat countries may move to theAustralian model . . . without adopt-

ing Australia’s fiscal rectitude.” In emerging marketeconomies, he said, “if the fiscal situation is goingwrong, most other things will follow.” He noted thatmany observers considered the success of inflationtargeting in New Zealand—which pioneered themove to inflation targeting—to be due in large partto the country’s putting its fiscal house in order at thesame time. Emerging markets that move to softerinflation targeting regimes should guard against get-ting soft, at the same time, about achieving their fiscaltargets.

In some cases, Leiderman said, the pressures on theinflation targeting regime come not from fiscal butfrom wage-setting institutions. Many emerging mar-ket economies turned to inflation targeting after ahistory of chronically high inflation; even though lowinflation has generally been achieved under inflationtargeting, in some countries—Leiderman suggestedMexico as an example—wage-setting institutionshave not yet fully adjusted to this change. Demandsfor wage increases made as though the old high-inflation regime were still in place will end upimparting inertia to the inflation process and makeachieving inflation targets more difficult.

The bottom line, Leiderman said, is that emergingmarket economies may encounter many obstacleson the path to an inflation targeting regime, butthese are surmountable. Inflation targeting hasworked very well for most of those that haveadopted it, at a time when they needed monetarypolicy autonomy and flexibility to deal with severeshocks.

In emergingmarkets, if thefiscal situationis goingwrong, mostother thingswill follow.

—LeonardoLeiderman

Photo credits: Ali Burafi for AFP, page 17; Denio Zara,

Padraic Hughes, Pedro Márquez, and Michael Spilotro

for the IMF, pages 17, 19, 21, and 22–30; Bjarke

Oersted for AFP, page 32. The photographs of the

NEPAD Conference that appeared on pages 11–12 in

Issue No. 1, January 20, were taken by Ibrahima Samba.

Israel missed yearly targets, but average performancewas close to target range for the period

Years Inflation target Inflation outcome

1992–2002 7.0 7.11992–1996 10.2 10.81997–1998 6.3 7.81999–2002 3.3 2.3Source: Leonardo Leiderman, “Inflation Targeting in an Emerging Market Context,” IMF InstituteSeminar, December 19, 2002. Figure on inflation outcome for 2002 is an estimate based on data for the first11 months of that year.

February 3, 2003

24

Coverage of the January 3–5 American EconomicAssociation meeting continues in this issue of the

IMF Survey. Asimina Caminis, Jeremy Clift, MarkusHaacker, and Sheila Meehan report on diverse subjects,ranging from the importance of institutions in eco-nomic outcomes and the role of information technologyin spurring growth in the United States to the growinglinks between the world’s economies and the prerequi-sites for poverty reduction.

Over the past decade, crises in emerging marketcountries and stalled development in sub-SaharanAfrica have prompted economists to reconsider therole of institutions in shaping economic outcomes.Several AEA sessions this year explored this subject inboth contemporary and historical contexts.

Institutions now. . . In the panel “NewComparative Economics,” Andrei Shleifer (HarvardUniversity, presenting the findings of an up-coming paper coauthored with J. Botero, S. Djankov,R. La Porta, and F. Lopez-de-Silanes) suggested itwas a good time to look at comparative systems. Indesigning institutions, he said, we should be trying toevaluate the roles of law and order, the rule of law,and government. His goal is to map where countriesare on a curve of “private orderings” (how neighborsresolve disputes among themselves, civil and com-mon law traditions, and government regulation) andhow technology and social organization can shift thatcurve. Shleifer argued that institutions that func-tioned well in their original environment couldfounder when “exported” to poorer, more disorderedstates. The more organic and flexible common law

traditions of Britain, he said, traveled better than themore formal and rigid traditions of French civil law.

Discussants in this session (MIT’s OlivierBlanchard) and in a later session (MIT’s DaronAcemoglu) noted the complexity of the links betweentheory, practice, and impact. Both cited the intricaciesthat attended the origins, forms, and applications ofcivil and common law.

In their paper, Stanley Fischer (Citigroup and pre-viously IMF First Deputy Managing Director) andRatna Sahay (IMF) marshaled statistical evidence tocounter the oft-made argument that the internationalfinancial institutions neglected institutional and ruleof law concerns in their single-minded quest torebuild the economies of the former Soviet Union.The data show, Fischer and Sahay said, that output

began to collapse when the old systemstarted to fail (not when transitionbegan), that structural reforms had astrong and positive impact on growth,and that initial conditions––whetherproximity to Western Europe or thelength of time under communism—mattered. The international financialinstitutions, they said, provided enormoustechnical assistance, and structural con-cerns weighed heavily, for example, in theconditions attached to IMF lending.

This measured argument was amplifiedby an impassioned defense of the IMF’shandling of the Russian crisis fromLawrence Summers (Harvard University,

previously U.S. Secretary of the Treasury). He arguedthat it was “ludicrous to say there was no attention toinstitutions” or that maintaining existing institutionswas a viable option. A fast-failing operation could notbe kept running, he insisted, and those who favored agradualist approach had to come up with a successfulexample of one.

Why does this debate still exert such a hold overthe public’s imagination? It is partly becauseSovietologists still have a vested interest in the topic,Summers suggested, but also because the laws of eco-nomics do not garner the respect that, say, the laws ofphysics do. He acknowledged, also, real concernsabout the dramatic declines in life expectancies andthe debate over whether the Chinese approach totransition from a state economy to a market economyheld out the possibility of a “different way.” Summers

Annual AEA meeting

Economists link economic well-beingto sound institutions

From left: StanleyFischer, AndreiSchleifer, andLawrence Summers.

February 3, 2003

25

argued that it did not—that the Chinese strategy wasunavailable to the more industrial and highly ineffi-cient Russian economy. Two hundred years fromnow, he predicted, history will look back at the for-mer Soviet Union and marvel at how unlike the fallof other empires its transformation was—happeningalmost without bloodshed and with a relatively rapidrecovery.

. . . and then. One of the AEA’s most intriguingsessions on institutions centered on four papers thatnever made it to the twentieth century. In fact, beforethe panel on long-run growth and institutions wasover, the discussion had shifted from trade to mar-riage and gone back in time to 1000 AD.

A question that has long puzzled economists iswhy Europe’s fortunes rose rather than those of, say,Asia. Daron Acemoglu (MIT), in a paper coauthoredwith Simon Johnson (MIT), argued that Europe’s risereflected the growing vigor of Atlantic port cities andthe institutional changes effected by the increasinglypowerful merchant class. In England, France, and theNetherlands, where existing institutions limited themonarchies’ claims on the proceeds of trade, thechanges were particularly striking.

Trade was also the focus of a study by Oded Galor(Brown University) and Andrew Mountford (Uni-versity of London), who examined why one-third ofthe world’s population is Indian and Chinese. In theeighteenth and early nineteenth centuries, in a criticalinteraction between trade and demographic transi-tions, trade emphasized the importance of skilledlabor, encouraged technological innovation, andfueled investments in human capital and smallerfamilies. In agrarian economies like those of Indiaand China, they said, much of this effect was delayedor inverted, with substantial implications for percapita income.

The human capital component, two other paperssaid, may tell an even more basic story. Eric Gould(Hebrew University) and his coauthors argued thatmonogamous marriages were a conspicuous featureof developed societies and reflected the growing valueplaced on human—rather than physical—capital andthe need for “quality” mates and offspring, which, inturn, greatly enhanced the bargaining power ofwomen.

Nils-Petter Lagerlof (Concordia University), ina paper coauthored with Lena Edlund (ColumbiaUniversity), broached a related topic, asking whatlove had to do with growth. According to theirresearch, quite a bit. The rise of Europe, they said,dates back to 1000 AD, when both population andGDP per capita income started increasing. Oneingredient in Europe’s takeoff, they said, was the

move away from arranged marriages. Lovemarriages spurred the transfer of wealthbetween generations and encouraged invest-ment in offspring; arranged marriages,Lagerlof said, tended to move wealth withinthe parental generation and to be associatedwith a stagnation of capital.

Will U.S. economic growth pick up?In a session devoted to globalization, the neweconomy, and growth in the United States,Martin Feldstein (Harvard University and theNational Bureau of Economic Research),Joseph Stiglitz (Columbia University), DaleJorgenson and Lawrence Summers (both ofHarvard University), Martin Baily (Institute forInternational Economics and McKinsey), andRobert Gordon (Northwestern University)debated the contribution of information tech-nology (IT) to the phenomenal growth of theU.S. economy in the 1990s.

Baily argued that IT investment contributedto productivity growth only if accompanied bybusiness process innovations that, in turn, wereinduced by the competitive pressure facingcompanies. Feldstein addressed the differencesin IT adoption between the United States andEurope and highlighted the role that incentivesfor business managers played in innovation.Stock options and an emphasis on shareholdervalue encourage innovations in the UnitedStates, he argued. European firms, however,have neither the incentive structure nor a cor-porate environment that supports change,which could involve significant layoffs.

Gordon and Jorgenson, who analyzed thesources of recent productivity growth, said theUnited States was unlikely to see a return of thehigh rates of labor productivity growth thecountry experienced in the 1990s. Conventionalgrowth-accounting exercises, according toGordon, underestimate the productivity effectsof IT investments because they fail to accountfor the lags in the adoption of existing produc-tion processes. However, inflation was helddown in the late 1990s because of a favorablemacroeconomic environment, including anappreciation of the dollar, low energy prices,and a temporary hiatus in medical care priceincreases. Much of the IT boom was fueled byonetime sources of demand, including theinvention of the World Wide Web. Jorgenson empha-sized that much of the increase in labor productivityreflected longer working hours, a trend that he said

Oded Galor

Eric Gould

Daron Acemoglu

Dale Jorgenson

February 3, 2003

26

could not continue. “Spread the word!” he concluded.“Economic growth is going to revert to [that of] the1973–95 period despite the new economy.”

Turning to developing countries, Stiglitz empha-sized that those that gained access to the new econ-

omy should be able to close the knowledge gap withthe advanced countries. Globalization as managedby the IMF has enhanced the prospects of somedeveloping countries, he said, but there is clear evi-dence that it has exposed some others to more risk,

Taylor cites successes of international monetary policy

In the Distinguished Lecture on Economics in Government,

John Taylor, U.S. Undersecretary of the Treasury for

International Affairs, argued that the interrelated goals of

productivity growth and economic stability were critical to

reducing poverty.

Comparing average per capita income in the United

States––$90 a day—with that in the world’s poorest coun-

tries—where 1.3 billion people live on less than $1 a day—

Taylor attributed the huge gap to differences in labor pro-

ductivity and urged the international community to make

productivity growth one of the Millennium Development

Goals. He dismissed concerns that productivity growth

might make the rich richer without benefiting the poor,

citing empirical studies that showed that higher productiv-

ity growth increased the per capita income of the lowest-

income quintile of the population by about the same

amount as the other quintiles.

According to economic theory, Taylor said, capital should

be flowing to where the returns are the highest—that is, the

poor countries—and these should be growing faster than

the advanced countries. This is not happening because of

impediments in poor countries to the inflow or use of capi-

tal and technology—namely, poor governance (weak rule of

law and corruption), poor education, and restrictions on

economic transactions (such as lack of openness to trade,

state monopolies, and excessive regulation).

He discussed new efforts by the Bush administration to

remove these impediments in the developing world. One such

initiative is the Millennium Challenge Account, to be estab-

lished in 2004, which would raise total U.S. foreign aid to

$16 billion by 2006. This aid will go to countries meeting cer-

tain criteria, such as “ruling justly,”“investing in people,” and

“encouraging economic freedom.” At the same time, the

United States will increase its contribution to the World

Bank’s International Development Association by $100 mil-

lion a year over three years, with the incremental increases

in the second and third years contingent on results. Nearly

100 percent of this aid will be in the form of grants, not loans,

for projects in education, health, nutrition, clean water, and

sanitation. Again, it will be confined to countries with good

policies.

In contrast with the disappointing performance of devel-

oping country economies, Taylor said that, over the past

15 years, “much good has happened” in the area of interna-

tional monetary policy. Forty-seven countries have adopted

the feasible and desirable “trinity” of flexible exchange rates,

low inflation rates, and monetary policy “rule” that estab-

lishes specific instru-

ments for targeting

specific goals (such as

low inflation). Fifty

other countries are

highly dollarized or

have joined currency

unions or adopted

currency boards, while

75 have fixed or heav-

ily managed exchange

rates. Only seven have

multiple exchange rate

systems. Central banks

are taking much stronger measures to combat inflationary

pressures, a strategic change that Taylor said had led not

only to lower inflation but also to greater financial stability

and greater stability in the real economy.

Turning his attention to emerging markets, he listed three

problems now confronting them: a “substantial increase in

the severity and frequency of crises” in the 1990s, a dramatic

decline in capital flows to these countries, and high real

interest rates. Taylor proposed a four-pronged strategy to

address these problems. First, the emerging markets must

get their policies right, while the IMF should concentrate its

efforts and conditions in the areas of its core competencies:

monetary, fiscal, and exchange rate policy. The seven major

industrial countries and the Group of 20 (19 industrial and

emerging market countries, the European Union, the IMF,

and the World Bank) need to develop better models and

indicators of financial vulnerability and emphasize eco-

nomic, rather than political, considerations in determining

which countries receive assistance.

Second, markets and donors need to better differentiate

between countries to reduce the possibility of contagion.

There has already been an improvement in this area, he said,

offering as evidence the contrast between reactions to

Russia’s default in 1998, which drove up interest rates for

countries in other regions, and those to Argentina’s default

in 2001, when spreads for other countries remained steady

or even decreased. Third, he stressed the importance of clar-

ifying limits on access to emergency loans from the interna-

tional financial institutions and the official sector and called

for a formal justification of exceptional access. Reliance on

large assistance packages should gradually decrease, in the

interest of debt sustainability, he said, and, to reduce uncer-

tainty in the wake of a crisis, countries should rely less on

large, unpredictable bilateral loans and more on IMF assis-

tance. Fourth, he called for reform of sovereign debt work-

outs to make them more orderly and predictable.

John TaylorTaylorurged theinternationalcommunity to make laborproductivitygrowth one of theMillenniumDevelopmentGoals.

February 3, 2003

27

discouraging debt financing and, indirectly, ITinvestment. Responding to Stiglitz, Summers notedthat some developing countries would be held backby geography and corruption, among other things,which could not be blamed on the IMF. As for theUnited States, he stressed the increasing share of theIT sector in the overall economy and noted thatproduct market competition, trade openness, a lackof barriers to entry, and an absence of restrictionscreated pressure that spurred innovation, which wasgood for productivity.

G-7 economies in tune?In another session, panelists examined whether,given the increasing links between the world’s econ-omies, the advanced economies were now synchro-nized or if policymakers could rely on strength inone market to compensate for weakness in another.Economists stepped up research on this issue when,after a decade of economic expansion, growth beganto slow simultaneously in early 2000 in the sevenmajor industrial countries (Group of Seven)—Canada, France, Germany, Italy, Japan, the UnitedKingdom, and the United States. But research pre-sented at the AEA conference, while supporting thesynchronization theory, was not conclusive.

Brian Doyle and Jon Faust (U.S. Federal ReserveBoard) said that a rise in the co-movement of GDPamong industrial countries would have importantimplications for the making of national economicpolicies. Governments, for example, would need totake closer account of forecasts for conditions abroadin formulating forecasts for their domestic economies.

But, while they found that there was a correlationamong Group of Seven growth rates during the cur-

rent slowdown, it was not bigger than in previouseconomic cycles. “Overall, despite manychanges in the international economy, the evi-dence does not reveal the arrival of a perma-nently higher correlation of growth ratesamong the Group of Seven,” they said.

Research by economists at the EuropeanCentral Bank (ECB) indicated that, while theeconomies of the Group of Seven were driven“to a substantial extent by common dynamics,”the impact of the North American economieson the economies of Europe was far biggerthan that of Europe on North America. Withglobalization, this asymmetry appeared to beincreasing.

Rasmus Ruffer (ECB) said it was clear that oilprices had an important influence on trends inGroup of Seven economies, particularly indownturns. But the asymmetrical influence ofNorth America and Europe on each other mer-ited further study.

Taking a different tack, Tamim Bayoumi(IMF) examined the impact of wealth—asmeasured by equity holdings and housing—on consumption. With interest rates increas-ingly running in parallel across the Group of Seven, trends in asset prices could be moreimportant for the health of Group of Seveneconomies. “It seems clear,” Bayoumi said, “thatdevelopments in asset prices are likely to becomeincreasingly important for policymakers because ofboth their direct impact on demand and—giventheir synchronization across countries—their role inthe transmission mechanism of business cyclemovements.”

Available on the web (www.imf.org)

News Briefs02/131: IMF Approves $16 Million Tranche to Bosnia and

Herzegovina Under Stand-By Credit, December 20

02/132: IMF Completes Third Review Under Djibouti’s

PRGF Arrangement and Approves $6 Million

Disbursement, December 20

02/133: IMF Completes Second Review Under Madagascar’s

PRGF Arrangement and Approves $15 Million

Disbursement, December 23

SpeechesOpening remarks for the IMF Sovereign Debt Restructuring

Mechanism (SDRM) Conference, Horst Köhler, IMF

Managing Director, Washington, D.C., January 22

“Emerging Market Debt: What Is the Problem?” Kenneth

Rogoff, Economic Counsellor and Director, IMF Research

Department, SDRM Conference, International Monetary

Fund, Washington, D.C., January 22

Press Releases03/07: IMF Statement on Kenya, January 21

03/08: Lucerne Conference on the CIS-7 Initiative, January 22

Public Information Notices03/09: IMF Concludes 2002 Article IV Consultation with

Colombia, January 23

Statements at donor meetingsIndonesia Consultative Group Meeting, Daniel Citrin, Senior

Advisor, IMF Asia and Pacific Department, January 21

Joseph Stiglitz

Tamim Bayoumi

February 3, 2003

28

In 1969, the IMF created the Special Drawing Right(SDR) as an international reserve asset to supple-

ment members’ existing reserve assets (official holdingsof gold, foreign exchange, and reserve positions in theIMF). In a new Working Paper, International Liquidityand the Role of the SDR in the InternationalMonetary System, Peter B. Clark, Senior Advisor in theIMF’s Research Department, and Jacques J. Polak,Director of that department from 1958 to 1979, describehow changes in the international monetary system haveundermined the role originally envisaged for the SDR.They argue that although the concept of a global stock

of international liquidity—funda-mental to the creation of theSDR—is no longer relevant, thereare still good reasons to satisfy partof the growing demand for interna-tional reserves with SDRallocations.

IMF SURVEY: How did the con-cept of a global stock of interna-tional liquidity become irrele-vant?POLAK: Over the past century, peo-ple interested in internationalfinancial policy—those working inuniversities, ministries of finance,and central banks—have focused agreat deal of attention on onequestion: Will the stock of interna-tional liquidity enable countries to

accumulate a level of reserves that can support contin-ued growth in the world economy? Several conferenceshave dealt with this subject, including two that wereheld immediately after World War I in Brussels andGenoa, the 1933 World Economic Conference held inLondon, and the 1944 Bretton Woods Conference.

But it was not until 1969 that an apparent resolu-tion of the question was found with the introductionof the SDR—a new form of international liquiditythat would allow the international community to cre-ate the amount of reserves that the world needed.At that time, reserve assets were mainly in the form ofU.S. dollars, whose supplies were constrained by theBretton Woods system of fixed exchange rates, andin gold. Increases in the supply of dollars to foreignholders threatened U.S. official gold holdings—a problem known as the Triffin dilemma.

Not much more than a decade later, the problemevaporated. It wasn’t that the SDR solved it. Instead,the problem itself went away when the United Statesgave up its commitment of gold convertibility of thedollar in 1971. All of a sudden, there proved to be analmost limitless stock of dollars and other major cur-rencies, which countries in need of reserves couldeither earn or borrow, thus taking away the very basisof the SDR.

IMF SURVEY: What influences the demand forreserves?CLARK: A country’s demand for reserves is related tothe size of changes in its balance of payments, typi-cally in the current account. In fact, there is a fairlyclose relationship between a country’s level of re-serves and its imports of goods and services. Overtime, fluctuations in the capital account have alsoassumed increasing importance. During recentcrises—in Asia, Russia, and Latin America—massivefluctuations in capital flows boosted the need forreserves to help ward off a crisis and moderate theimpact of capital outflows on exchange rates.Research at the IMF and elsewhere suggests that theratio of reserves to short-term debt may be a keyindicator of reserve adequacy in countries with sub-stantial, but uncertain, access to capital markets.Greater capital market integration tends to increasethe demand for reserves.

There are also situations in which countries’demand for reserves may decline. For example, tothe extent that countries move from relatively fixedto flexible exchange rate arrangements—that is, theyrespond to external imbalances by allowing the price,rather than the quantity, of foreign exchange toadjust—the need for reserves to intervene in the for-eign exchange market would be expected to dimin-ish. Many observers thought this would occur withthe demise of the Bretton Woods par value system,but reserves have continued to grow significantlyover the past 20 years. Even if a country only lightlymanages its exchange rate, with a relatively closedcapital account it would still want to hold reserves—and probably increase them over time—to helpsmooth output fluctuations arising, for example,from large movements in its terms of trade.Moreover, research indicates that the shift to floatingrates has not been as dramatic as popularly believed.Ken Rogoff and Carmen Reinhart have found that

Interview with Clark and Polak

SDRs could meet growing demand for reservesat no cost while reducing systemic risk

Clark: “The mainargument for SDRallocations is thatSDRs can becreated essentiallywithout cost—other than avery smalladministrativecost.”

there is little evidence of countries—other than themajor industrial countries—moving significantlytoward floating exchange rates. So, the shift to float-ing is perhaps more apparent than real, and it hasn’thad any clear impact on the world’s long-termgrowth in reserves.

IMF SURVEY: What options are open to countries inacquiring reserve assets?CLARK: One way is for a country to improve its cur-rent account. But that requires it to reduce domesticdemand—give up the use of resources for consump-tion or investment. Obviously, this involves a realresource cost, which is measured by the country’s rateof return on investment and is typically manifestedin a market-determined interest rate in that country.The rate is fairly low for some emerging market econ-omies and industrial countries, but for many othercountries it is quite high. A country can also obtainreserves by issuing foreign-currency-denominatedbonds in international capital markets or by borrow-ing from banks at market interest rates. It could thenhold these reserves in the form of deposits or short-term assets in the major reserve currency countriesto earn interest.

IMF SURVEY: How about the terms?CLARK: These can vary widely. Most advanced coun-tries can borrow at interest rates that are only slightlyhigher than the return on reserve assets. They can sat-isfactorily finance increases in reserve holdings byborrowing in international capital markets and there-fore really have no need for an SDR allocation to sup-plement reserves. However, for other countries—largely emerging market economies—the differencebetween the interest rate on their sovereign bondsand the return on reserve assets is typically muchhigher. They must also deal with dramatic changes inthe availability of funds and the terms on which theycan borrow, as we have seen in times of crises. Forthese countries, borrowed reserves are a useful sup-plement to owned reserves acquired through currentaccount surpluses, but they are often unreliable andtheir cost can vary significantly, particularly whencountries need them most.IMF SURVEY: Despite changes in the internationalmonetary system, you still make a case for SDR allo-cations to improve the system’s operation and tomeet most countries’ need for reserves. Why?CLARK: First, most countries wish to add to theirreserves over time. Second, adding to reserves is costlythrough both current account adjustments and bor-rowing. The main argument for SDR allocations isthat SDRs can be created essentially without cost—

other than a very small administrative cost. Thisargument is analogous to substituting fiat currencyfor commodity currency—that is, the substitution ofcurrencies for gold clearly saves society the resourcecost of digging gold out of the ground and storing it.Third, SDRs can reduce systemic risk. Rather thandepend on borrowed reserves, countries would haveaccess to more owned reserves, which would reducetheir vulnerability to changing conditions in interna-tional capital markets. They also wouldn’t have to payinterest to borrow reserves, making them a bettercredit risk.

IMF SURVEY: Why can’t the IMF simply provide morecredit, rather than distribute new reserve assets?CLARK: Conditional credit is, of course, very impor-tant for the IMF. But there is no reason the IMF’sactivities should be restricted to conditional financ-ing—that is, under IMF programs. The IMF itself hasalways recommended that members not dependexclusively on conditional reserves. Indeed, an ade-quate stock of owned reserves is, in almost all cases,a condition in IMF programs. Since the recent bal-ance of payments crises, the IMF has urged membersto build up their stock of owned reserves and hasissued a number of papers on reserve managementemphasizing the role of reserves in reducing a coun-try’s vulnerability to crises.

IMF SURVEY: If the IMF’s membership were to back aresumption of regular SDR allocations, what wouldbe their optimal timing, frequency, and size?POLAK: Much of the criticism surrounding the idea ofSDR allocations is based on the misconception thatcountries would suddenly receive a large amount ofmoney that they would be very tempted to spendinstead of hold as reserves. That was never the idea ofthe SDR mechanism. On the contrary, given thatcountries wanted to consistently build up their

February 3, 2003

29

Jacques J. Polak(left) andPeter B. Clark:“Since the recentbalance ofpayments crises,the IMF has urgedmembers to build up their stock ofowned reserves.”

February 3, 2003

30

reserves in line with the increasein their international transac-tions, the idea was that alloca-tions would be made annually totake care of this slowly growingneed. Allocations shouldn’t be aonetime event. They should takeplace regularly, annually or evenquarterly, in modest amounts.CLARK: The question of theoptimal size of an SDR alloca-tion is a difficult one, even for asingle country. The answerwould require consideration ofa range of variables, includingthe cost of acquiring reserves,the cost of adjustment in theabsence of reserves to financepayments imbalances, and acountry’s risk preferences.To make estimates for all mem-bers would be a daunting task.The past approach to SDRallocations involved estimatinggrowth in demand for reservesand then judging what fraction of that growthshould be satisfied by SDRs. It is important not tomake the allocation so small as to be inconsequentialor so large as to cause concerns about inflation.POLAK: A fundamental element of the design of theSDR system was that the size of the allocation to acountry would be based not on its need for reservesat a certain time but on an objective measure thatwould reflect the country’s relative need for reservesover the long term. After much discussion, it wasdecided that, in the absence of a better alternative,IMF quotas would serve as that measure.

IMF SURVEY: Since the last allocation of SDRs in1981, there has been considerable resistance to addi-tional allocations. Why?POLAK: This resistance, which dates back to shortlyafter the first allocation in 1970–72, comes fromindustrial countries. Some of them considered thelast allocation to be a political arrangement and not alogical extension of the SDR system because, by then,many of the changes in the international financialsystem that we talked about earlier had alreadybecome evident. Industrial countries have easy accessto capital markets, so they don’t need the SDR sys-tem. That wasn’t so at the time the SDR was createdin the 1960s.

In addition, some may find awkward the idea of asingle institution—the IMF—providing both condi-

tional and unconditional credit inthe form of SDRs. Industrialcountries, in particular, have diffi-culty with this concept. But theirobjection to SDR allocations—helping debtor countries main-tain an adequate level of reservesat no cost to the creditor coun-tries—is curiously inconsistent,because these same countries arebearing the considerable cost ofproviding very low interest loansto finance other capital needs ofthe developing countries throughIDA [World Bank’s InternationalDevelopment Association] loansand the IMF's concessional loanfacility.

IMF SURVEY: Do you have anyreason to be optimistic that thisresistance can be overcome anytime soon?POLAK: I’m not at all optimisticthat it can be overcome in the

near future. In the mid-1990s, industrial countriesfavored a special SDR allocation to help channelresources to Russia and other countries that had beenmembers of the former Soviet Union. And in 1997, atthe [World Bank-IMF] Annual Meetings in HongKong, the IMF’s Board of Governors finally endorsedthis allocation, but it hasn’t become a reality becausethe United States has not passed the necessarylegislation.

While SDR allocations are no longer favored bymost industrial countries, they have recently receivedattention in nonofficial circles. For example, theZedillo Report—prepared for the UN InternationalConference on Financing for Development held inMonterrey, Mexico, in March 2002—advocates aresumption of SDR allocations, and George Soroshas put forward a proposal to use SDRs to financeexpanded foreign aid. Although these proposals werenot endorsed in the Monterrey Consensus, at leastthey were given consideration.

Industrialcountries haveeasy accessto capitalmarkets, sothey don’tneed the SDRsystem. Thatwasn’t soat the timethe SDR wascreated inthe 1960s.—Jacques J. Polak

Polak: ”Much of the criticism surroundingthe idea of SDR allocations is based onthe misconception that countries wouldsuddenly receive a large amount ofmoney that they would be very temptedto spend instead of hold as reserves. ”

Copies of IMF Working Paper No. 02/217, InternationalLiquidity and the Role of the SDR in the InternationalMonetary System, by Peter B. Clark and Jacques J. Polak, areavailable for $15.00 each from IMF Publication Services. Forordering information, see page 21.

February 3, 2003

31

W ith the prospect of its membership increasingsubstantially over the next few years, the

Governing Council of the European Central Bank(ECB) has proposed a system of rotating voting rights toensure efficient and timely decision making. Before theCouncil’s December 19, 2002, proposal, the IMF’s HelgeBerger analyzed the ECB’s different options.

At a landmark summit meeting held in Copenhagenin December, the 15 members of the European Union(EU) agreed to admit 10 new members, paving the wayfor their accession in May 2004. The 10 are Cyprus, theCzech Republic, Estonia, Hungary, Latvia, Lithuania,Malta, Poland, Slovakia, and Slovenia. Three otherstates have candidate status: Turkey, which has beentold that it must wait at least two more years beforestarting talks on joining, and Bulgaria and Romania,which appear on course for accession in 2007.

The expansion will pose special challenges for deci-sion making within the EU’s institutions. While join-ing the euro area is a second step after being admittedto the EU, most observers foresee the possibility ofmembership in the euro area increasing from the cur-rent 12 (EU members Denmark, Sweden, and theUnited Kingdom have not yet joined the euro areabut may do so) to 24 by the end of the decade.

Such rapid growth in membership could have severeconsequences for the efficiency of monetary policy-making in the euro area, according to Berger, whoseanalysis was published in an IMF Working Paper, TheECB and Euro-Area Enlargement. Without revision ofthe current ECB statute, the doubling of the number ofeuro-area member states would increase the size of theECB Council from 18 to 30 (see box), making it by farthe largest monetary policy–making body amongindustrial countries. Discussion and voting procedureswould likely become more time consuming and com-plicated. The central bank tradition of consensus-

based policymaking—said to play an important role intoday’s ECB decision-making process, too—could fur-ther amplify the large number problem and increasedecision-making costs.

Emerging mismatchAn increase in euro-area member states would also belikely to increase the overall wedge between the eco-nomic and political weights of member countrieswithin the ECB, according to Berger. Currently, allmember states have equal voting power within theCouncil, and policy decisions are based on a simplemajority-voting rule. Since almost all the accessioncountries are small in economic terms relative to cur-rent euro-area members, enlargement within theexisting institutional setup would significantlyincrease the mismatch between the smaller membercountries’ voting share in the ECB Council and rela-tive economic size. Such “overrepresentation,” whilenot necessarily a problem, could, nevertheless, intro-duce an unwelcome bias into the ECB’s decision mak-ing, Berger suggests.

To address these problems, the ECB’s GoverningCouncil in December proposed a system of rotatingvoting rights. The proposal would restrict the size ofthe Council by limiting to 15 the number of nationalcentral bank governors who can vote. Once there weremore than 15 member countries in the euro area, arotating voting system would apply. The five largesteconomies would form one group and share 4 votesthat would be rotated among them. The remainingcountries would share 11 votes, also on a rotating basis,and (once there were more than 21 euro-area members)would be organized into two groups. According to theECB proposal, within each of the resulting three countrygroups, countries would exercise their voting right withdifferent frequencies depending on an indicator of theirrelative economic size that has yet to be fully specified.The EU’s Council will have to take into account theopinions of the European Commission and the Euro-pean Parliament on its proposals. Each participatingcountry would also have to ratify it.

Other possibilitiesA rotating voting system was not the only possiblereform, Berger says. He also looked at the followingalternatives in his paper:

• Centralization: Decision making could be central-ized, for instance, in the hands of the six members of

The euro

European Central Bank plans reformsto cope with EU enlargement

How the ECB is run now

The ECB is run by a Governing Council and a six-person

Executive Board. The current president is Willem F.

Duisenberg. The Council is the supreme decision-making

body and comprises the heads of the central banks of the

12 member countries of the euro area and the 6 members

of the Executive Board. The Council formulates monetary

policy and sets interest rates for the euro area. It usually

meets once a fortnight.

The EUexpansion willpose specialchallenges fordecisionmaking withinits institutions.

February 3, 2003

32

the current ECB Board. The role of the ECBCouncil would be reduced to that of a forum todebate decisions, curbing the participation ofnational central banks.

• Weighted voting: Another possibilitywould be to introduce weighted voting—forinstance, by GDP or population share—fornon-Board members of the ECB Council.

• Group representation: Alternatively, votingrights could be allocated jointly to groups ofnational central bank governors, with grouprepresentatives voting in the ECB Council.

Of these suggestions, Berger says, both thecentralization and the rotation schemes offer asomewhat more complete solution to the prob-lems euro-area enlargement poses for the setting ofmonetary policy in the euro area. Both weighted votingand group representation could ensure that ECB Councilmembers carry a political weight roughly in proportionto economic size—that is, the Council would be broadlyrepresentative of the entire euro area. But the large num-ber of policymakers involved under these reform scenar-ios (directly or indirectly) could be reason for concern,Berger notes. Approaches that aim to centralize decision-making power or reallocate it through an asymmetricrotation scheme (where the rotation frequencies varyby country) can address not only the possible wedgebetween the economic and political weights of councilmembers but also the issue of decision costs.

Full centralization might not be optimalWhile full centralization—which has been proposed bysome—has many advantages, Berger says, a number ofinformational and political economy considerationssuggest that giving the Board sole power over monetarypolicy decisions might not be optimal. For instance, thepresence of national central bank governors in the ECBCouncil is often viewed as helping with the productionand processing of information originating on theregional level. There is also the pragmatic (or legalistic)consideration that full centralization would fail to safe-guard the established voting rights of current membercountries’ central banks—a safeguard that was an inte-gral part of the Maastricht Treaty that created the euroarea. Moreover, as Berger explains in his paper, a rolefor national central banks in ECB decision making,while potentially problematic on other grounds, couldcontribute to the independence of the euro-area centralbank. These arguments suggest that reforms shouldensure that the Board continues to play an important,but perhaps not dominant, role in the ECB Council asthe euro area grows. The reform proposal put forwardby the ECB’s Governing Council, which implies only alimited reduction in the relative voting share of the

Board compared with the status quo, seems to followthis line of thought.

Organizing the presence of national central bankgovernors in the ECB Council along the lines of a rota-tion scheme could help limit the overall number ofvoting Council members without sacrificing regionalrepresentation. Rotation would mean that, at any giventime, a portion of euro-area countries as represented bynational central banks could vote at ECB Councilmeetings, while all bank governors could be present.Under the ECB’s reform proposal, about 75 percent ofthe area’s GDP would be represented, on average, byvoting governors. Even though this percentage coulddrop to about 60 percent in some circumstances(because of the rotation of countries within the threegroups—a possible disadvantage of the plan), the pro-posal would still secure strong regional representation.

In addition, if rotation frequencies were selectedasymmetrically to reflect the relative economic sizeof the respective countries—a feature of the ECB’sreform proposal—rotation could ensure the congru-ence of the political and economic weights of euro-area member countries.

Berger’s analysis suggests that, while some aspectsof the ECB’s reform proposal deserve further atten-tion and clarification, the proposed rotation schemestrikes a reasonable balance between ensuring theefficiency of the Council’s decision making as euro-area membership increases and securing the partici-pation of the new members in the setting of mone-tary policy. This balance should help in the politicalarena and increase the prospects of ECB reformbefore euro-area enlargement actually takes place.

This article is drawn from IMF Working Paper 02/175, The ECB andEuro-Area Enlargement, by Helge Berger. Copies of the paper areavailable for $15.00 each from IMF Publication Services. See page 21for ordering information. The full text of the ECB’s press release onthe proposed rotating voting system is available on the ECB’s websiteat http://www.ecb.int/press/02/pr021220en.pdf.

Laura WallaceEditor-in-Chief

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Prakash LounganiContributing Editor

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(L-R) French President Jacques Chirac, French Foreign MinisterDominique de Villepin, and Polish Prime Minister Leszek Miller at theEU summit in Copenhagen, Denmark, December 13, 2002. Polandis one of the ten countries that will accede to the EU next year.