4 – 6 MAY 2009 rev 1 - VISIT TO WASHINGTON DC, UNITED STATES - ECS SUB-COMMITTEE ON TRANSATLANTIC ECONOMIC RELATIONS

I. MEETING AT THE WORLD BANK – THE BANK’S RESPONSE TO THE GLOBAL ECONOMIC CRISIS

2.  The meetings at the World Bank focused largely on the global financial crisis and the developing world.  Although the crisis has been very serious for OECD countries, it is now having a deeper impact on developing countries with grave humanitarian and security implications. Moreover, in the developing world, the food and energy crisis have had a far more serious impact, particularly as food costs consume a far higher percentage of consumer spending in developing countries. For the first time in decades, global GDP has declined and trade is plummeting.  No country has escaped the consequence, but conditions vary considerably by country and by region. There has been a huge decline of capital flows to developing countries, and this is making it very difficult for these countries to finance current account deficits.  The World Bank estimates that the financing shortfalls stand between $270 and $700 billion. It is not yet clear how the shortfalls are going to be met or if they will be rolled over. Much depends on how the current crisis plays out over the next several months.  If conditions stabilize, the shortfall will lean toward the 270 billion figure; should conditions worsen greater shortfalls can be anticipated. In any case, many countries are borrowing heavily and this could trigger a crowding out effect that will adversely hit developing countries, particularly those suffering serious current account shortages.  The collapse of world trade is obviously worsening these balances for many developing countries and they have very little financial means to respond.

3.  It is estimated that last year some 150 million people fell below the World Bank’s poverty line of $1.52 a day and another 50 million have done so this year. Poor people obviously have very little reserves to deal with worsening economic conditions. Oftentimes poor families are compelled to sell off assets like farm animals which are crucial to their livelihoods. Children are withdrawn from school, visits to the doctor are curtailed and the quality of nutrition declines. All of these can have lasting developmental effects.  Developing countries, moreover, have no fiscal space to deal with these multiple crises and it should hardly be surprising that many development experts are suggesting that achieving the Millennium Development Goals will be all the more difficult in the current environment.  

4.  The Bank has called on the developed world to set aside funds to help developing countries weather the current storm.  It is highly conscious of the need to maintain social safety nets and wants to target funds to help developing countries do so.  It is also hoping to use funding to support infrastructure projects to lay a foundation for growth. Agricultural production and small and medium enterprises are also priorities. The Bank has tripled its lending to the poorest countries and the International Bank for Reconstruction and Development (IBRD) will spend $35 billion this year and in each of the next two years in order to pursue these ends. The Bank is working to front load some of these funds so that they can have an immediate stimulus effect in countries without the fiscal resources to engage in expansionary fiscal policies. The crisis itself originated in the United States, spread quickly to the G 7 and then moved to the middle income and finally the poorest countries. The needs of the poorest countries are only now growing apparent and the bank is now mobilizing support for these countries and intends to triple its so-called social lending.

5.  The Bank also recognizes that different countries confront very different sets of problems and need different kinds of support. Some countries face sharp falls in remittance earnings, some are suffering because of commodity price falls, while others have been hit by declining trade or capital flows. Eastern Europe is hit by a serious financial crisis which has become the epicentre of the global financial crisis and the Bank is working with the European Bank for Reconstruction and Development (EBRD) and others to provide some support there. The World Bank and other development agencies have to be very sensitive to these differences. The International Financial Corporation (IFC) is taking the lead in helping the private sector help developing countries weather the crisis. The Bank, through the Infrastructure Recovery and Assets Program (INFRA) is also supporting public investment programs which, if neglected during a crisis, can have harshly negative effects on long-term growth, making economic recovery all the more difficult. Finally, the Bank is supporting efforts to help the most vulnerable, and thus to mitigate the social costs of the crisis.  The Global Food Crisis Response Program (GFRP) is helping small holder farmers in today’s very difficult climate.  The Bank’s board has just approved $2 billion for this program.  There is also a program to support the social safety nets for the urban poor. Keeping children in school and assuring their access to health clinics remains a priority.

6.  There is not yet a consensus on whether the Bank should be granted a capital increase and, of course, many donor countries are engaged in massive stimulus policies that are consuming national financial budgets. Out of 104 developing countries 84 are experiencing budget problems and very few have the means to respond to the external crisis alone.  Loans from the Bank are not sufficient; grants from the international community are also needed.  But the developed countries will also need to work to keep the global trading system open and functioning while setting aside funds to help keep developing countries afloat in these extraordinary times. Developed countries must also take care not to lock up stimulus programs and prevent any leakages abroad. This could cause the global system to freeze up.

7.  The poorest countries have only recently begun to feel the impact of this crisis which originated in the developed north. Emergency requests are now flooding into the Bank, and it has had to move quickly to respond. The Bank’s private sector lending arm has also increased lending in response to this surge in need. It is appealing to developed countries to bolster funds for the developing world.   The Bank feels it has sufficient funds to weather the storm for the next two years but it will need to replenish its capital thereafter if the crisis is prolonged. One thing that is clear today is that achieving the Millennium Development goals will be all the more difficult in the current environment.  Governments in the OECD are facing political pressures to slash development budgets.

8.  Participation in the governance of the Bank poses another challenge that the crisis has accelerated. In a process that lasted two years, negotiators agreed to accord developing countries a greater share of voting rights in the Bank. But this change only conceded 2% more voting power to developing countries - an inadequate amount given the vocation of the Bank and the growing importance of the developing world in the global economy.  It is important to grant developing countries a greater voice in the Bank’s management, but donor countries are reluctant to give up their own shares.  Some, like the Nordic countries, provide far more funds than their size might warrant but are not accorded an equivalent say in decision making. So there are pressures all around on this question.   A seat for sub-Saharan Africa has been added to the board but there has been no corresponding shift in the voting shares for Africa.  Currently there is a 44% voting share for developing countries and 56% for the developed world. The goal is to move to parity but this will require developed countries to forfeit a modicum of their voting privileges. The president of the Bank has appointed a commission under the leadership of Ernesto Zedillo to explore the governance question in greater depth. The Bank has also worked to enhance its transparency and to broaden its disclosure list.

9.  The Bank is working to be more responsive to the needs of recipient countries and has revised its approach to conditionality issues. The Bank once imposed an average of 35 conditions on each loan it extended. Today that number has been reduced to ten, and five of these are focused on environmental sustainability, while only two might be called socio-economic. Far greater attention is now being paid to preserving social safety nets, but there is also a need to keep an eye on those outlays that will bolster future growth and development.  It is a matter of balancing productive growth tomorrow and employment and social security today. The Bank has also reduced response time to requests for assistance from 18 months to two or three months depending on the information at hand.

10.  The current financial crisis has imposed very difficult conditions on the World Bank.  National, regional and global assessments have been constantly revised downwards.  Today the world is undergoing the first global decline in GDP in decades and all regions are being affected.  

11.  The Bank’s private sector financing facility, the IFC, has also boosted its activity in response to the current crisis. Here too the challenges are formidable as financing for small and medium sized enterprises is drying up. Agricultural concerns in the developing world are a particular worry as farmers are having trouble raising essential finance to get their fields planted. World food prices are very high, but this has not helped. If farmers cannot respond to higher prices, then shortages can be anticipated which would further drive food prices up. This poses a real threat to food security.  The IFC is working to help fill these gaps. It is underwriting a very extensive microfinance program with over 130 million clients. It has now created a microfinance enhancement fund to instil continued confidence in the microfinance industry and to catalyze uninterrupted access to this vital form of funding for the smallest businesses. It is also trying to help emerging market banks fill capital shortfalls arising out of the current crisis.  It is helping governments and banks to transfer non-performing loans to the private sector for processing, to foster sustainable and prudent policies for dealing with these non-performing loans.  There is today over $400 billion of private sector debt that has to be rolled over.

A. CLIMATE CHANGE

12.  Climate sustainability has become a greater priority for bank lending in recent years. Climate change will have a more devastating impact on developing countries than on developed ones. The World Bank hopes to help build up developing countries’ resilience to climate change and indeed to increase their capacity to adapt to it, although donors are also attaching a high priority to mitigation efforts as well.  The Bank is providing some concessional financing to support these efforts and is also conducting research on the costs of adaptation.  The potential impact on coastal cities is under study.  The Bank must also wrestle with the paradox that development itself can contribute to climate change, and this too must be factored into Bank policy.  The Bank approaches energy projects with this in mind and now runs a fund to underwrite the adoption of clean technologies.  It is also supporting forestry efforts to create ozone sinks. Climate investment funds are engaging many stakeholders from both donor and developing countries. The Bank is scaling up demonstration projects. Some of the proposals have included the financing of an intelligent electrical grid in Turkey, lighting systems in Mexico and various wind power projects. The Bank, however, is not working on nuclear power issues although it has begun to examine this as an option, although a very expensive one for the Bank’s core clients.  Clean coal, however, is attracting ever greater interest.

B. FRAGILE STATES

13.  The Bank is also increasingly engaged in fragile and conflict-affected countries which pose a broad range of unique challenges.  Paul Collier at Oxford has done a great deal of work on this.  War and conflict have left many countries in a highly precarious state, with roughly a billion people living in the midst of political conflict and fragile political structures.  The costs to human life are significant, and the damages are estimated to approach $100 billion a year.  Many of these conflicts are regional rather than civil and include the problems in Pakistan and Afghanistan, the Great Lakes Region of Africa, the horn of Africa and the Arab-Israeli conflict.  Moreover, once a conflict has ended there is a very high chance (40%) of relapse. The financial crisis is making the situation all the more difficult in conflict ridden societies. 

14.  The World Bank has a country rating index for fragile countries. The list now includes 35 states of which 20 are in Africa. The Bank has categorized fragile states into those where governance is deteriorating, those in prolonged crisis, those operating in post-conflict conditions and those on the road to improvement.  It has established a rapid response framework to deal with emergency situations. The Bank is participating in a working group with the OECD working on questions ranging from state legitimacy to development and conflict. It has prepared some guidelines that help define state fragility including measures of state effectiveness and the sense of nationhood. It is also incorporating governance factors into these measures. Security and politics themselves are outside the mandate of the World Bank, but it is collaborating with the EU and the UN in this work. There are now ten OECD DAC principles on engaging with fragile states including guidelines to help prevent conflict, peace building and state building. These seek to achieve visible results on the ground, forge partnerships, mobilize financial resources for these countries and generate learning from real experiences. President Zoellick has pointed to the preconditions for development to begin. These include state legitimacy, security, justice, a degree of economic stability and a sense of local ownership. 

C. AFGHANISTAN

15.  Clearly in the development field, special considerations have to be made for very impoverished countries like Afghanistan which are in the midst of armed conflict. But there are also middle income countries like Iraq and Lebanon which are also at risk. The Bretton Woods system was put in place precisely to begin the process of post war reconstruction. Its first loans were to France to rebuild its destroyed rail network.  The Bank continues to finance reconstruction efforts, although the context is often very difficult. It follows the OECD DAC principles and places a high priority on ensuring that programs encourage conflict prevention. It provides grants to many of these countries from IDA (the International Development Association of the World Bank), manages trust funds that help ensure aid coherence to fragile and war torn states, and helps fund the salaries of national officials.

16.  The Bank has built a partnership with NATO and is also working with the UN on early recovery efforts after conflict. The Bank has increased staffing for these efforts and has a roster of staff that can be called in the event of an emergency. It has assembled a $100 million peace building fund from which to draw. The Bank has committed 1.7 billion in IDA assistance to Afghanistan to underwrite public administration, infrastructure, education, health, customs transport and rural development. The Bank is also administering the Afghanistan Trust Fund. It extends local grants through the National Solidarity Program and works with elected village councils to administer this program.  So far $601 million in small loans have been made to some 20, 000 borrowers, and these have generated very high returns approaching 30%.

17.  From the Bank’s perspective, much of the work it has conducted in Afghanistan over the past decade has been relatively successful. There have been important strides made in health delivery, gender programs, leadership development, rural road construction, the strengthening of the Ministry of Finance and in currency reforms. There is now capacity to deliver certain government programs. There has been perhaps greater success in some rural areas than in the cities. Bank studies suggest that the greatest single determinant of success in that country is the quality of ministerial leadership. Of course, the insurgency continues and there has been a deterioration of the security situation since 2005. This has made it very difficult for development work in many parts of the country.  The Bank is determined to deliver services wherever possible and even uses satellite images to assess projects it is funding in regions that are too dangerous to visit.  Today roughly half of the country is reasonably safe, but security for aid workers remains a real concern.  The Bank is doing very little work in the tribal regions of Pakistan although it is supporting a Pakistan poverty alleviation program.  It has applied some of the lessons learned in Afghanistan to these programs including innovations like parental moderating of schools and stipends to underwrite the costs of sending children to school.  The Bank has worked with other organizations including the UN to come up with counter-narcotic strategies. Many tenant farmers are not generating much revenue from poppy production although larger landowners are. Although eradication might have some effects on these large landowners, for the small farmers improved rural access to roads and support for switching to crops like grapes could work as Afghanistan does have significant agricultural potential. It needs access to markets in North America and Europe if it is to successfully deal with this challenge. Today drug sales account for 50% of national income.

D. FOOD SECURITY

18.  Food security issues were also taken up in discussion at the Bank.  This is a multifaceted crisis and is continuously evolving. Even the swine flu epidemic has had an impact as it, like the avian flu crisis, has precipitated animal culls which could affect local food supplies and prices.

19.  The Bank has established a global food crisis program, which includes a $2 billion facility to ensure a rapid response to food emergencies. The Bank is convinced that the food crisis of last year is not over. Volatility is likely to continue and this poses major problems as it undercuts investments needed for future harvests.  The Bank is currently working with 30 countries to forge appropriate responses to soaring food prices.  Part of this effort is to discourage taxation on food that might restrict agricultural trade. There are also efforts underway to underwrite food productivity enhancement and build new links between farmers and markets.

20.  Last year between March and July, food prices soared both in the developed and developing world.  Conditions however varied considerably. Some countries that are self sufficient in rice saw little change, while important rice importers like the Philippines were struck very hard.  At one point, the Philippines simply could not find any rice on the markets and this helped drive rice prices through the ceiling.

21.  This situation led many countries to the conclusion that they had to protect their markets and restrict food exports which only exacerbated the problem. Oil price volatility has been a second factor.

22.  The key to ensuring adequate supply is ensuring access to land, water, energy seeds and fertilizers and, of course, access to markets. All of these are fundamental to food security. Only 4% of Africa’s arable land today is irrigated. This is not a problem of water per se; it is rather a problem of investment. In Asia nearly 50% of the land is irrigated and this is why Asian yields approach those of Europe. African yields are only 15% of Europe’s. Water is a key problem.

23.  A second problem is technology and seeds. In Africa there are roughly seven kilograms of fertilizer per hectare, while the figure for Europe is eight to nine tons.  That is a factor in the huge productivity gap.  The Bank established a fund last year that helps small farmers get access to seeds and fertilizers and greater access to markets. Credit is a particularly important problem and farmers cannot increase productivity without it.  But the global financial crisis is drying up credit and this is hitting farmers precisely when they need to boost production to meet rising prices. European farmers have been able to do this, but many developing country farmers have not.  There is a real risk that production could be worse this year than last year despite the rise in prices.  Another problem here is that fertilizer prices have quadrupled as did transport costs for fertilizers last year. All of this meant that returns to poor farmers fell last year and the risks to them were even greater.  Few creditors are willing to take risks, and the Bank has worked to develop instruments get capital to the countryside.  Huge investments in water saving technology are also needed as water demand is slated to soar.

24.  Another factor is that the Saudis, Koreans and the Chinese have been purchasing land in developing countries to help them meet domestic food needs. There are tens of millions of hectares of land for lease in the developing world. This is not necessarily a bad development if it is done right. New investment can generate jobs and bolster productivity.  The problem is that many of these land tenure arrangements are not clear.  They could become a source of conflict, and there are also environmental and water use factors that need to be considered. These deals need to be made more transparent and the Bank has worked to understand these deals.

25.  Climate change is also a factor in the food crisis and the Bank is investing in forestry but here too there are problems. Indigenous peoples are being stripped of their rights in tropical forests and the use of these forests is changing quickly. They are needed as carbon sinks and to provide for the livelihoods of these indigenous peoples. So this too is a worrying trend and it is fostering serious social tensions, for example in the Amazon region where there is a need to acknowledge and defend the rights of indigenous peoples and where these rights can be effectively given a value.

26.  Biofuels are also playing a significant role in linking food and energy prices particularly because US corn production is being diverted into ethanol production. Only a small faction of the world’s grain is actually traded on world markets, but this means that a small diversion of this 10% of total production can have a significant price effect. The United States actually accounts for half of the world’s traded grain. Thus when the United States shifts its policies, this can have a massive effect on world supplies and prices.  The United States is the largest grain exporter even though China is the world’s largest grain producer. Subsidies in the west were once used for production, but they are increasingly used to underwrite multi-functionality. This has important effects on global food markets and has been a factor in food price shocks. Brazil today is the only country producing and selling biofuels without subsidies.  The business seems economically legitimate, but it may be less so in more northern climes where subsidies are being used to prop up a biofuel industry that is not necessarily energy efficient.  The Bank also notes that the potential for switch grass could be overrated as grasses do, in fact, compete for farm land.

27.  Agriculture and land use account for 30% of the human contribution to global warming. So farming is both part of the problem and part of the solution. Farming can be structured to enhance carbon capture, and this should be part of the deal made in Copenhagen. But it is not clear that this will even be addressed.  This is an area that also requires a great deal of scientific research.  For example, livestock is a major contributor to the greenhouse gas methane. There are feeds that can reduce the production of methane significantly. Feeding cattle grass rather than corn reduces methane production by 50%. Subsidies ought to be structured to encourage grass rather than corn feeds which are not natural for cattle.  Fertilizer technology has also failed to evolve since World War II, and it seems like this is another area that can benefit from more serious research support.  There is also a role for GMOs, although Europe is generally very hostile to genetically modified foods.

28.  More broadly, the Bank feels that small farmers should be able to sell food on global markets and this is the best way to advance development in rural areas and help moderate food price wings.  Today the pressures on the land are growing. In a global crisis, millions are returning to the land as jobs dry up in the cities. This could lead to social unrest and a hunger crisis.  The world will eventually have to double food production and it will need a great deal of land and water to do so. But technology is going to have to be part of the solution.

II. MEETINGS AT THE IMF – THE CRISIS IN CENTRAL AND EASTERN EUROPE

29.  At the IMF the delegation first discussed the situation in Eastern Europe, which the Fund believes has become the epicentre of the global financial crisis.  For nearly a decade Eastern and central Europe have been growing at a very rapid pace - nearly 6% per annum in the run-up to the crisis. This was far above rates in the Euro area. Growth was due to strong global growth and the good policies adopted in much of the region.  FDI flowed into the region, and Eastern and Central Europe’s geographic position was immensely helpful.  Western banks played a key role in moving capital into the region, and this capital stood at nearly 9% of GDP in 2007.  This inflow, in turn, was a factor in booming domestic demand.  In Ukraine and Russia, terms of trade gains linked to commodity price rises boosted incomes significantly.  Oil and metals prices were soaring, and this tended to reinforce confidence. 

30.  At the same time fiscal deficits fell throughout the region from 8% to 2% of GDP, and a range of reforms were implemented. Yet there were important differences as well. In general terms, much of the region liberalized and integrated with Western Europe. Institutional frameworks were upgraded to prepare these countries for the rigors of European Union membership and public sector policies also improved. Credit growth expanded dramatically and much of the lending, fatally, was denominated in foreign currency.  At the same time current account deficits soared due to this influx and the rise of trade deficits.  Credit to GDP ratios rose substantially. In 2008, Latvia’s bank credit stood at 102% of GDP while in Estonia foreign currency loans were 120% of GDP.  If Estonia were to abandon its Euro peg, its debt burden would soar. Hungary has also accrued a very high level of foreign currency denominated debt and this is driving the crisis there now. A number of West European banks are now highly exposed to the region as a result of excess lending there.  Their exposure has risen from $158 billion in 2002 to almost  $1 trillion in 2008.  Austrian and Swedish banks have been particularly exposed with Austria exposure level nearing 70% of GDP and non-performing loans rising sharply. Latvia and Bulgaria have seen current account deficits peaking at roughly 25% of GDP; the US current account deficit was 6% of GDP by comparison, and this was considered high! In much of Central and Eastern Europe private sector debts have also soared.

31.  This is not the first time that emerging countries have been the source of generalized financial concerns. The Latin American crisis in the late 1970s and Asia in the 1990s immediately come to mind.  The vulnerabilities of Central and Eastern Europe, however, really only became apparent after the failure of Lehman Brothers in September 2008.  At that point, risk premia began to rise sharply.  The spread on Ukrainian bonds, for example, rose to 34% at one point as foreign investors became concerned about risk levels there.  Turkey, Hungary and the Czech Republic were also struck by high risk premia. Global deleveraging, fuelled by Western banks calling in loans, has thus led to a collapse in capital inflows to the region.  The initial impact of the crisis was in the United States and Western Europe, but it was quickly felt in Eastern Europe.  Growth rates have now plunged into the negative, and the IMF suggests that the impact will be felt for an extended period, in part because the Euro area, the critical market for Eastern Europe, has been so profoundly struck. Indeed this crisis has radically lowered global trade levels and global industrial production. Because trade relations between Eastern and Western Europe are so strong, the trade impact of the crisis has been magnified in Eastern Europe.

32.  The IMF is now projecting that the global economy will contract in 2009. Central and Eastern Europe will face a decline of some 4%, and the US roughly 3%. These are large and worrying falls. In the region, Poland is expected to decline far less than its neighbours, while the Baltic States and Russia face the worst situation with estimates under constant downward revision.  Latvia’s economy shrank by 5% last year and will fall close to 15% this year - these are declines that are far steeper than those during the Asian crisis.

33.  The IMF is now working to mitigate the impact of the global crisis in the region and beyond. The crisis has essentially ended a debate about the ongoing relevance of the institution as it has become a key player in managing the impact of the crisis.  The Fund’s loan portfolio is rising very rapidly and emerging Europe is now the largest customer.  Because much of the region ran up significant current account deficits for extended periods, managing the current correction will remain a critical task.  The Fund is providing liquidity to ease the shock.  The dilemmas for the region are very serious as adjustment, either by running down reserves or profound exchange rate adjustment, each pose very serious problems.  The IMF is providing capital to help smooth out the downturn and make it less deep.  It is essentially providing liquidity buffers to prevent national economies from seizing up.  There is no alternative to adjustment, but this liquidity helps ease the shock. There are, of course, limits to what the IMF can accomplish, and it is not positioned to prevent a recession.  Many of these countries were managing economies in a manner that was unsustainable and there is no alternative to adjustment. That adjustment is already underway, painful as it is, and it involves plummeting demand, falling current account deficits, declining inflation and negative growth.

34.  It is worth noting that the IMF had been warning about both regional and global instabilities for some time but it was very difficult to sell that message during a global upswing. There were different views on the vulnerabilities of emerging Europe. Some felt that the rapid increase in credit was a serious problem while others argued that this was appropriate given the growth prospects of the region and the accession of many of the region’s countries to the EU. This reassured investors and lenders and was one reason for substantial and indeed unsustainable capital inflows.  The IMF itself was particularly concerned about the Baltic region.

A. THE IMF’S ROLE IN MANAGING THE GLOBAL CRISIS

35.  As suggested above, one of the signs that this has been a remarkable crisis has been the constant downward revision of growth estimates. One year ago, the IMF predicted a global growth rate of 0.5%, and there was very little sense of alarm. The situation, of course, subsequently worsened considerably. It is now evident that the world economy had been growing at an unsustainable level up to 2006 and now it is moving below the long term trend line.  The collapse of credit markets has had a profound global impact, but no where more than in Central and Eastern Europe.  In past crises, the developed world remained relatively robust, and emerging economies could rely on them for support. That is not the case this time around.  Trade has collapsed and this is depriving crisis struck regions from exporting their way out of their economic dilemmas. 

36.  In response to this situation, the IMF has called for a relaxation of monetary and fiscal polices in the developed world to essentially create a floor on the crisis.  The IMF has dramatically increased its lending and now it is higher than it ever has been by a factor of two. This does not include programs that are soon to be unveiled. Plans to triple the IMF’s funds make sense. The Fund is now offering a flexible credit line to countries with a strong macro-economic track record to bolster their capacity to weather the storm.

37.  The IMF has conducted a study on the lessons of the crisis and found that the surveillance capacity of the Fund and many central banks was inadequate.  If warnings were issued in the runup to the crisis, these were, at best, very vague. This was hot helpful and efforts are needed now to develop early warning mechanisms that will be taken more seriously. Dealing with this problem is extraordinarily difficult because it is almost contrary to human nature to consider and take action on warnings when economic times are good. Governance procedures of the fund are also under review.

38.  Banking surveillance has also been a serious problem. IMF surveillance of the world’s five most important economic areas: the US, the UK, the Euro Zone, Japan and China will now include a survey of the banking sector. The goal is to bring these issues to the table in a more coherent fashion.  Regulation policies will need to be revamped, particularly in light of the fact that a shadow banking sector had emerged throughout much of the OECD and was operating outside of proper regulatory frameworks. Central Banks are also going to have to revisit the permissible size of banks as the recent crisis demonstrated that many banks had become too big to fail and that this, in turn, led to a moral hazard problem. There are calls today for the Fund to exercise greater leverage over strategic players so that its warnings are taken seriously - something that has not been the case in the past.  But the IMF is not a rule-making body like the WTO, and so here too there are limits to what it can accomplish.

39.  There has also recently been a revival of Keynes’ old notion of having the IMF run by senior policymakers and not international civil servants in Washington.  This would more deeply engage national governments in the life of the institution. Some see this as promoting a potential conflict of interest although others argue that it would ensure a degree of political accountability within the institution.

40.  The IMF has also begun to re-examine and streamline conditionality policies. It has not entirely eliminated these, but based on the Asian crisis experiences it is working to target lending conditions on fundamental and relevant macro-economic policy matters rather than use conditions to impose a broad range of policy prescriptions. When governance matters are “macro-critical” the IMF will attach conditions to loans. The IMF recognizes that it cannot solve all problems and must focus on its core mandate.

B. MEETING WITH JOHN LIPSKY, FIRST DEPUTY MANAGING DIRECTOR OF THE IMF

41.  John Lipsky spoke to members of the Committee at a luncheon the IMF hosted.  He noted that after undergoing the greatest economic downturn since World War II, the Fund now expects positive growth later this year. He suggested that unemployment will remain a major challenge as it is a lagging indicator. Excess industrial capacity will help contain inflation despite loosening monetary and fiscal policies. He also indicated that the fiscal stimulus countries have implemented has been essential to keeping the world economy afloat. The breadth and depth of the policy response is unprecedented.

42.  The fiscal response in 2010 will be as important as in 2009.  Automatic stabilizers will have fully kicked in by then, but this will mean a very significant increase in budget deficits although these will have to fall eventually.  This, in turn, points to the need for medium-term guidance and credible strategies to return to fiscal rectitude.  It is also important to recognize that periods of subpar growth have long lasting impacts. It is therefore essential to continue core investments so that long-term productivity is not undermined. Health care is one of those areas in which neglect today can have long-term adverse implications.  At the same time, banks need liquidity but also must clean up their balance sheets and recapitalize for the long-term. The United States has been working on all three and has just completed the conduct of stress tests on major financial institutions.  More broadly, all developed countries have had to address problems of information and transparency, regulation and inefficiencies in markets.  Innovative strategies are needed to ensure fiscal stimulus without over-burdening national budgets. One simple rule is to seek to broaden the tax base while lowering the rates and simplifying tax rules.

III. MEETING AT THE BROOKINGS INSTITUTION

43.  The visit in Washington concluded with discussions at the Brookings Institution on the financial crisis, the state of Transatlantic Relations and the Middle East.

A. THE FINANCIAL CRISIS

44.  In the discussion on the financial crisis, it was pointed out that some studies suggest that without the stimulus package the United States has adopted, the decline of US GDP would have been 9% rather than 3%.  The United States has worked hard to recapitalize the banking system. The Federal Deposit Insurance Corporation (FDIC) has provided a blanket federal guarantee on debt in addition to ensuring deposits.  This is helping to ease credit markets and recapitalize the banks.  The losses to US banks over the past year have been staggering and could be as high as $1.8 trillion according to some estimates although this does seem high. Nonetheless, if losses are that high, then the banks would have to be nationalized.

45.  A second critical policy has involved moving toxic assets off the books of the banks.  This has added stability to the banks. The Obama administration has proposed moving these into special institutions and paying 30 cents on the dollar for these assets. The government will essentially provide incentives to over pay for these assets, but there are concerns that this will not work.  The problem is that the banks believe that these assets are worth 60 cents on the dollar, and it is very difficult to convince them of the need to sell them for less.

46.  Moral hazard poses a genuine problem in all of this and there are concerns that banks have not received a sufficiently powerful signal. Clearly regulations will have to be tougher in the future.  Larger banks will need tougher capital adequacy requirements and that these should be applied broadly.  Hedge funds could pose problems here, and reforms will be needed. For example, credit default swaps will now be conducted through transparent and regulated exchanges where collateral can be better monitored. Auditors have become more independent, but there will always be an asymmetry here as the banks will have the resources and the talent and the capacity for innovation which will put them a step ahead.  Although regulation of the sector is clearly needed, it is best to approach the challenge nationally. The United States and many other countries are not going to turn over regulation to an international body although there is room for greater international coordination.

B. THE STATE OF TRANSATLANTIC RELATIONS

47.  Afghanistan ranks among the greatest US priorities for the transatlantic relationship.  President Obama is now working to regionalize the approach and to engage both Pakistan and Iran in a possible solution.  It openly acknowledges, however, that it also needs military, civilian and material support from its European allies, particularly as the United States has dramatically ramped up its presence in country.   US officials want to avoid the perception and the reality that this is an American war and if it becomes so, it will undermine the relationship. The US military is now applying the counter-insurgency lessons learned in Iraq to Afghanistan.

48.  As for Russia, the buzzword in Washington is reset; in other words, the administration will work to find common ground with Russia.  The United States will push for a follow on to the START talks and will show flexibility on missile defence.  It also wants a stronger commercial relationship with Russia and may try to bring it into the WTO. That said, the United States simply cannot ignore Russia’s dramatic retreat from democratic norms nor can it recognize Russia’s apparent claims on territories beyond its border in the post-Soviet space. Ukraine will very likely remain a sore point between Russia and the United States as will Georgia. For the moment, the Ukrainians have removed themselves from the NATO accession game as there is no consensus in that country for this course. But there are still many things that can be done. The Ukrainians can work on the content of MAP because it is in their interest to do so whether or not they join NATO or are extended a MAP invitation. It might be wise to lower the temperature on the Ukrainian question as accession is not likely to come up over the short term.

49.  Russian forces are now taking over border observation posts in South Ossetia and Abkhazia and the overall posture of Russia in the Southern Caucasus is hardy promising. The speed of Russia’s response to Georgia’s moves into South Ossetia suggests that it had already mobilized its forces for the move into that territory. It is also fairly evident that the United States had communicated to Georgian officials that they would be on their own if they moved on South Ossetia. The Obama administration now wants to depersonalize relations with Georgia, particularly as the opposition movement is strengthening. But he also wants to avoid signalling that Russian tactics have worked. 

50.  In the Middle East, the Obama administration faces a very trying situation. Hamas has gained popularity among the Palestinian people while Fatah has been severely weakened.  The broader Arab community will need to put pressure on the Palestinians to work to find a common voice for future status negotiations.  George Mitchell has already begun working on this angle but he will not speak with Hamas. On the Israeli side the US relationship with Netanyahu will be difficult, particularly as the United States will take a tougher position on the settlements. Turkey is working to bring Syria to the table and achieving this is critical.

51.  More broadly, Obama has shown that he is very preoccupied with trans-national challenges including nuclear proliferations and global warming and poverty.  Global governance is a matter with which he will have to deal. The administration recognizes that it is not positioned to dictate terms to the international community and will seek dialogue with the other critical countries including China. There is a sense that the G 8 forum is too narrow to manage the global agenda, while the G 28 is too large and there are no permanent mechanisms for any of these configurations. This may have to change.

52.  On global warming, the attitude of the new administration is totally different than that of the Bush administration but Europe would be making a mistake to expect radical change in US policy in the short run. It will not want to appear to be a deal breaker in Copenhagen but it is constrained by a range of factors that will not allow it to move too quickly. The US administration will take a studied approach to the question and will eventually come up with a serious package of proposals.  This will be partly predicated on technology dissemination and sharing as well as mitigation measures. It will not likely move quickly to embrace a global cap and trade system in the middle of a global financial crisis. To do so would be premature.

53.  In Africa, Obama will want an agenda that is not driven by the Department of Defense and set it in a broader political and policy context.  This is true of other regions as well; many in the new administration feel that the Bush administration overly militarized US foreign policy. President Obama has raised the civilian foreign affairs budget by 11% and he hopes to give the State Department greater weight in the inter-governmental process.