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Analytical Studies

Issue Objectives for the Genoa Summit Meeting 2001:
Exchange Rate Management, International Financial Institutions and World Economy

Exchange Rates

The impact of the economic slowdown in the past six months has not hit forex markets worldwide as hard as expected. Both the US dollar and the Japanese Yen have remained relatively strong against the Euro. However there have been some notable developments. The latest 25 basis point cut in Federal interest rates by the US Treasury, the 6th cut this year for a total 275 basis points, has been forecasted to weaken the dollar slightly over the pound and the euro.

The simultaneous package of reforms announced by the Japanese government that entailed a zero-growth forecast and painful readjustments in the short-run, slid the yen to its lowest point against the dollar since early 1999. The Yen is expected to weaken further in the near future. However, Masajuro Shiokawa, Japan's finance minister, indicated in the last week of May that the current pricing of the yen does not justify concerted intervention. The yen has held strong against the euro.

The euro has demonstrated a fluctuating pattern over the past year while declining gradually against the dollar. The weakness of the euro has helped export competitiveness while limiting the ability of the European Central Bank to respond as low exchange rates inflate import prices. Yet, the ECB president, Dim Duisenberg, has, like the Japanese, also expressed an apparent lack of concern over the euro currency rate, stating it was "not a threat that preoccupies us very much."

Similarly, Gordon Brown, the UK Chancellor in a June speech has preferred to maintain the status quo regarding adopting the Euro; officially membership talks are not forthcoming but the government continues to espouse a pro-euro realist outlook. The British pound is showing potential signs of strengthening as data shows that the Bank of England is at or near the bottom of the cycle. Furthermore, Britain is likely to benefit from the increasing interest rate differential between the US and Britain.

International Financial Institutions

G7 finance ministers and central bankers met in Palmero, Italy in February of this year. The general theme of the meeting turned out to be that the campaign to reform the IMF and the World Bank was still strong. While efforts at reforming the so-called global financial architecture on the surface may appear to be moving at a glacial pace, the G7 has been steadily increasing the scope of its demands for change at these institutions, and the gathering in Palermo, Sicily offered much of the same.

The newest member at the G7 discussions, US Treasury Secretary Paul O'Neill, also has expressed strong reservations about past practices at the IMF and the World Bank, and is likely to intensify US pressure-and perhaps offer a reworked US reform agenda. Among the first and most discussed issues the US Treasury was tackled under the Bush presidency has been the need for better economic crisis prevention, using the IMF in particular as an early warning station for potential financial turmoil globally while reducing its bailout role. Past crises, the new Treasury secretary has declared, stemmed largely from a "failure of anticipation."

O'Neill's remarks to this effect at the G7 were reflected to some degree in the communiqué issued at the meeting's conclusion. While any concrete plan for reform at the Bretton Woods institutions could not be deciphered from the statement some hints could be perceived nonetheless.

In particular, the first item in the list of reform objectives outlined in the communiqué was "prioritization of IMF conditionality," which goes to the heart of IMF lending practices. The G7 and the US Treasury are expected to step up demands for the IMF to overhaul the way it looks at loan conditionality, clarifying the specific targets a nation must meet to secure IMF support, and establishing a more uniform set of basic conditions.

Russia is likely to be offered as a clear example of the failure of past IMF loan conditionality, while at the same time presenting the earliest opportunity to exhibit a new IMF approach in this area given current negotiations in Moscow toward a new IMF standby loan. At the same time, officials within the G7 are dismayed that Russia remains so resistant to IMF prescriptions of legal, economic and financial reform, despite 10 years and almost constant dialogue and billions of dollars in IMF and World Bank loans. With the Russian economy enjoying the fruits of a boom built on last year's surge in oil prices and the lingering impact of its 1998 currency devaluation, Moscow will face even louder demands from the G7 and the IMF that it cease prevaricating and show concrete progress on reforms. "We call upon the Russian authorities, as they address the difficult and complex process of economic transition, to implement a credible program of reform, and create the essential market institutions, and infrastructure for sound growth," the G7 officials said in the communiqué. "In this context, we encourage the Russian authorities to continue to work with the IMF and the World Bank."

Meanwhile, signalling a renewed spirit of cooperation, at the G-7 meeting in Palermo Russian Finance Minister Alexei Kudrin said that, contrary to previous statements from Moscow, Russia would seek to change it budget to allow it to begin paying off the $5.9 billion owed this year to other countries in the Paris Club.

The G7 pledged to finalize a reform manifesto for the World Bank and other multilateral development banks for presentation to G7 leaders at a summit in Genoa in July. The G7 communiqué stated, "Key principles of the reform [plan] are: greater selectivity in setting priorities; focus on the needs of the poorest; effective and transparent internal governance; and improving developmental impact,"

This is likely to require further clarification of development bank roles, interest rates charged according to a borrower's past performance and policy track record, better disclosure of loan documents, and greater accountability for the outcome of loan programs, the G7 said. This reform effort "will be a key focus when we next meet in Washington in April," O'Neill added.

Meanwhile, G7 finance ministers and central bankers in Palermo for the first time committed themselves to meeting the UN target of reducing poverty by half by 2015. The ministers said their commitment should make a difference to policies such as relations with international institutions. "The agreement here today that we are going to make it a priority to get resources channelled to social services-health and education-is very important," Gordon Brown was quoted as saying in Palermo. G7 sources said the UN targets had long been regarded as outside the domain of finance ministers and the responsibility of the development community and UN agencies. But now that the people in charge of the finances of some of the world's richest countries were on record as wanting to achieve them, there was every prospect that they would become more than aspirations. A program of work has begun which it is hoped will lead to the World Bank and IMF being required to spell out exactly how the UN targets will be achieved in the countries they lend to and supervise, the story notes.

Further, finance ministers at the meeting expressed optimism that prospects for continued global growth remain good despite economic troubles in the US and Japan.

Also the G7 finance ministers meeting in Palermo failed to come up with any new ideas on debt relief for poor countries, drawing fire from campaigners who had hoped for progress. In their communiqué, G7 finance ministers and central bank chiefs said the group had brought 22 of the world's poorest countries into the so-called Heavily Indebted Poor Countries (HIPC) debt relief initiative last year. They also said they would work to ensure those countries benefited fully from HIPC over the coming years, which would eventually see two-thirds of their debts written off.

But there was no response to calls by campaigners to include new countries in the HIPC process or to call in independent auditors to the IMF and the World Bank to check their ability to extend their share of debt write-offs. "The G7 are on dangerous ground," said Jamie Drummond, spokesman for "Drop the Debt". "Unless they move quickly, they are not going to build the foundations of a new deal on debt at Genoa."

World Economy

In the past year the world economy has experienced slower growth and instability in financial markets and has resulted in repercussions everywhere. Global economic growth is set to weaken still further in the month's ahead. In 2000, world growth averaged 4.9% yet the EIU forecasts that global economic growth in 2001 will be 2.9%, the slowest rate recorded since 1998. In spite of these predictions global growth is forecast to accelerate to 3.7% in 2002. Inflation has been increasing in recent months due to rising oil and food prices. Share prices have been decreasing and profit warning from companies have cast much doubt in the international scene. World trade figures confirm the world's weakened economic state. According to the World Competitiveness Yearbook from the International Institute for Management Development, the US continues to be the world's most competitive economy despite its economic slowdown, Germany is in 12th place leading the European countries, followed by UK in 19th place, France in 25th and Italy in 32nd place. Japan is rated at 26th place, down from its high ratings in the 1990's.

In Canada, Bank of Canada officials are optimistic about the country's position, however economic growth remains sluggish. Bank governor David Dodge has predicted a growth of 3% as the economy begins to pull out of a slowdown closely linked to the American economy lag. The high energy prices have been driving up inflation in Canada's economy as it has most everywhere and the Bank of Canada is eager to guard against price increases. Dodge's concern about the impact of inflation on the Canadian economy may suggest an unwillingness to cut interest rates any time soon. Dodge believes that although the economy has slowed dramatically due to decreasing demand of Canadian exports by the U.S., the economy is showing signs of recovery. He predicts an economic expansion in the second half of the year and further into 2002. Recently, slow business plant and equipment investment as well as falling exports were offset by strong gains in personal consumption and government expenditure. Despite these gains, Canadian GDP growth for the second three months of the year was a modest 1-1.5%.

In most recent news, the U.S. Federal Reserve made the decision to cut short-term interest rates by a quarter of a percentage point, a total cut of 2.75% points which is the most in two decades. The federal fund rate was also reduced from 4% to 3.75%, its lowest since April 1994. The cuts are in light of declining company profitability and capital spending, weak expansion and consumption and slowing growth. The easing monetary policy is also a tactic to reduce pressures in the labour and product markets in order to keep inflation down. The policies of bank governor Alan Greenspan are described as the most aggressive easing of money and credit in the past 14 years. The Feds are concerned about a strong dollar, which undermines US exports. US trade of goods and services fell in April, decreasing overseas demand for US goods. Business sales have fallen over the last 4 months and growth in real personal income has flattened. The National Bureau of Economic Research believes the United States is already experiencing its first recession in a decade.

Among all the European nations, the United Kingdom, while still experiencing an economic lag, appears to be in a better situation than its EU counterparts. A leap in construction output and surging stocks of unsold goods has resulted in a faster than normal growth of the economy in the first quarter, however economic imbalances remain severe. The economy grew by 0.5% in the first 3 months of the year, which is above the 0.4% estimate made earlier, but is still below its historical average growth rate. Wages and salaries are up by 2.1% as well as a rise in government spending by 0.8%. On the downside, the UK has experienced a 0.7% fall in manufacturing output and a 2.7% fall in investment and in general business confidence has been hit by the global economic slowdown.

In Germany, chancellor Gerhard Schroder emphasized deteriorating world conditions in explaining the German slowdown, particularly the slowdown in the American and Japanese economies. Germany has shaken confidence of avoiding a recession in Europe. Germany's export-driven economy has been impaired by decreasing demand from the US, one of the country's prime export markets. Domestic inflation has also intensified and has led to a reduction in consumer spending. Germany's leading economic institute has almost halved its growth forecast for the country. The economy is expected to grow by a meager 1.2% this year, lower than its earlier prediction of 2.1% growth and significantly lower than last year's 3% growth. This revision has serious consequences for the European Union in view of the fact that Germany is the largest European economy and accounts for nearly 1/3 of the economic output. Germany is assured of finishing the year with the worst growth rate within the European Union.

Italy's economy is also feeling the effects of the global slowdown. This year, Rome is expected to exceed the deficit target it has pledged to its European partners by a significant amount. Italy's tax revenues have also been experiencing a drop as a result of the slowdown in the economy. In France, consumer confidence has dropped to its lowest level since September 2000 providing further evidence of an economic slowdown within the nation. The government is still predicting a growth rate for the year of about 2.7 and 3.1%. First quarter figures show that GDP is growing at 0.5% compared to an earlier estimate of 0.8%.

Although the European central bank president Wim Duisenberg assured that recession was not looming over the euro-zone economy, the European economy is moving at quite a slow rate, evident from the economies of its member countries. Euro zone inflation reached a yearly rate of 3.4 % last month, its highest level since the euro's launch in January 1999 and above European Central Bank's target ceiling of 2%.The European Cantral Bank cut its key interest rate by a quarter-point in May but has held off on any further reductions because of the threat of inflation. In fact, the only country in the European Union that is below the optimum 2% level of inflation is the United Kingdom.

In Russia, President Vladimir Putin told EU leaders that Russia's economy was growing due to liberal tax and customs policies and furthermore the government had created a friendlier and more attractive environment for international investors. These comments come a month after Putin's fears over the economy back in April. Russia's eagarness to join the World Trade Organization could very well be the reason for such a change of heart. Deputy minister for economic development and foreign trade, Maxim Medvedkov, believes that there are no economic reasons to delay Russia's entry as sees Russia's exclusion as a cause of lost business deals and loss of income for Russian companies as well as for their trading partners.

In Japan, the economy has been very hardly hit. Recently, Prime Minister Junichiro Koizumi formally approved a restructuring plan aimed at healing the Japanese economy. Officials hope that growth can rise to about 3.5% once the reforms outlined in the economic plan kick in, however Economic Minister Heizo Takenaka said the economy will probably be flat or grow by no more than 1% over the next 2 to3 years. As for the fiscal year ending in March, the government has predicated a mere 1.7% growth.

Emerging markets have also suffered from the fragile world economic condition. Net private capital flows for emerging markets are at their lowest since 1992 due to financial problems in Turkey and Argentina. GDP growth is also expected to slow to 3.5% this year from more than 5.5% last year. The uncertainties in the major economies are believed to be suppressing capital flows in the emerging markets. At the G8 Summit, a gathering of the world's leading industrialized economies, we can expect the weakened world economy to be a very important topic on the agenda of all countries.

Prepared by Anju Aggarwal and Nicol Lorantffy

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