Romania:Country Report IMF

Romania’s recovery continues, but headwinds from the regional economic downturn and financial turbulence have severely weakened future prospects. Preliminary GDP data for Q3 show a strengthening of the recovery, driven by an exceptional agricultural harvest and continued strong industrial output growth. Domestic demand has begun to recover, with growth turning positive in construction and retail sales bottoming out. The labor market is also beginning to recover, as job growth has turned positive and real wages have started to rise. However, the euro area crisis is likely to sharply slow growth in the coming quarters. The net export contribution to growth has already slipped. International financial market uncertainty has produced a sharp rise in CDS spreads, which will feed through into domestic interest rates, slowing investment and consumption. Inflation has eased considerably, and is now expected to be within the authorities’ end-2011 target range (3 percent ± 1 ppt.). The current account deficit is expec ed to remain below 5 percent of GDP.

Romania has continued its strong performance under the new program. The authorities met all performance criteria and indicative targets for the third review. Performance under the structural benchmarks was more mixed. Benchmarks on bank restructuring legislation and governance legislation for SOEs were met. Those on SOE privatization and a review of the investment portfolio were partially met, but are expected to be completed by the time of the Board meeting.

The authorities are on track to achieve their 2011–12 deficit targets, but steppedup efforts are needed on key structural reforms. The 2011 deficit target of 4.4 percent of GDP (in cash terms) will be met, and underspending should give the authorities resources to help pay down arrears in key sectors (health care and SOEs). The 2012 budget has been prepared with the objective of a cash deficit of 1.9 percent of GDP (2.1 percent of GDP including some off-budget expenditures), lower than strictly necessary to attain their 3 percent of GDP objective in ESA terms with the EU. While the tight expenditure control needed to reach this goal will be challenging, no new major policy changes will be required. A freeze in pensions and wages, together with additional EU support for the investment budget should deliver the needed adjustment. Progress on the ambitious structural reform agenda has been mixed. Governance legislation for SOEs has advanced, but deregulation efforts in the energy sector have lagged. SOE reforms have moved well in some firms, while remaining inadequate in others. The government shows continued commitment to the measures agreed, but political opposition is intensifying as the 2012 elections approach.

Country Report No. 12/11. January 23, 2012

Romania:Country Report IMF

x

The Challenge of Public Pension Reform in Advanced and Emerging Economies

IMF. This paper reviews past trends in public pension spending and provides projections for 27 advanced and 25 emerging economies  over 2011–2050. In constructing these projections, the paper incorporates the impact of recent pension reforms and highlights the key assumptions underlying these projections and associated risks. The paper also presents reform options to address future pension 

Public pension reform will be a key policy challenge in both advanced and emerging economies over coming decades. Many economies will need to achieve significant fiscal consolidation over the next two decades. Given high levels of taxation, particularly in advanced economies, fiscal consolidation will often need to focus on the expenditure side. As public pension spending comprises a significant share of total spending, and is projected to rise further, efforts to contain these increases will in most cases be a necessary part of fiscal consolidation packages. Pension reforms can also help avoid the need for even larger cuts in pro-growth spending, such as public investment, and help prevent the worsening of intergenerational equity caused by rising life expectancies (at a pace faster than expected) and longer periods of retirement. Finally, some pension reforms, such as increases in retirement ages, can raise potential growth. Thus, while the appropriate level of pension spending and the design of the pension system are ultimately matters of public preference, there are several potential benefits for countries that choose to undertake pension reform. Against this background, this paper provides: (i) an assessment of the main drivers underlying spending trends over recent decades; (ii) new projections for public pension spending in advanced and emerging economies over the next 20 to 40 years; (iii) an assessment of the sensitivity of the country projections to demographic and macroeconomic factors, and risks of reform reversal; and (iv) country-specific policy recommendations to respond to pension spending pressures.

Pension spending is projected to rise in advanced and emerging economies by an average of 1 and 2½ percentage points of GDP over the next two and four decades, respectively, and is subject to a number of risks. During 2010–2030, increases in spending in excess of 2 percentage points of GDP are projected in nine advanced and six emerging economies. There is considerable uncertainty with respect to these projections, but risks are on the upside for a number of countries. Under a scenario where life expectancy is higher than anticipated—life expectancy projections have in the past underestimated actual increases—pension spending would be over 1 percentage point of GDP higher than projected in 2030 in five economies. Under a low labor productivity scenario, pension spending would be over ½ percentage point of GDP higher in three economies. Sizable risks are also associated with implementing enacted reforms as well as contingent fiscal risks if governments have to supplement private pensions should these fail to  eliver adequate benefits.

The appropriate reform mix depends on country circumstances and preferences, although increasing retirement ages has many advantages. It is important that pension reforms do not undermine the ability of public pensions to alleviate poverty among the elderly. Raising retirement ages avoids the need for further cuts in replacement rates on top of those already legislated, and in many countries the scope for raising contributions may be limited in light of high payroll tax burdens. Longer working lives also raise potential output over time. In many advanced economies there is room for more ambitious increases in statutory retirement ages in light of continued gains in life expectancy, but this should be accompanied by measures that protect the incomes of those who cannot continue to work. In emerging Europe, one possible strategy would be to equalize retirement ages of men and women. In other emerging economies, where pension coverage is low, expansion of non-contributory “social pensions” could be considered, combined with reforms that place pension systems on sound financial footing, including raising the statutory age of retirement. Where average pensions are high relative to average wages, efforts to increase statutory ages could be complemented by reductions in the generosity of pensions. Where taxes on labor income are relatively low, increasing revenues could be considered, and all countries should strive to improve the efficiency of payroll contribution collections.

INTERNATIONAL MONETARY FUND. Prepared by the Fiscal Affairs Department.Approved by Carlo Cottarelli.December 28, 2011. 

The Challenge of Public Pension Reform in Advanced and Emerging Economies x

Foreign Banks: Trends, Impact and Financial Stability

This paper introduces a comprehensive database on bank ownership for 137 countries over 1995-2009, and reviews foreign bank behavior and impact. It documents substantial increases in foreign bank presence, with many more home and host countries. Current market shares of foreign banks average 20 percent in OECD countries and 50 percent elsewhere. Foreign banks have higher capital and more liquidity, but lower profitability than domestic banks do. Only in developing countries is foreign bank presence negatively related with domestic credit creation. During the global crisis foreign banks reduced credit more compared to domestic banks, except when they dominated the host banking systems.

Although interrupted by the recent financial crisis, the past two decades have seen an unprecedented degree of globalization, especially in financial services. Not only have crossborder bank (and other capital) flows increased dramatically, but also many banks, from both advanced and developing countries, have ventured abroad and established presence in other countries. Although there are exceptions and regional differences, few countries have been left out from this trend of increasing financial integration. As a result, foreign banks have become important in domestic financial intermediation. For example, in terms of loans, deposits and profits, current market shares of foreign banks average 20 percent in OECD countries and close to 50 percent in emerging markets and developing countries.

Given the importance of foreign banks in many countries, understanding the motivations of foreign banks to enter a particular host country, the mode by which they do so, and the impact they have on financial sector development and lending stability has become essential. These questions have become even more prominent as a result of the financial crisis. Although much research has been conducted, many questions remain unanswered, however, partly because data availability has been limited.

This paper contributes to the literature on foreign banking in two ways. It introduces a new and comprehensive database on bank ownership, including the home country of foreign banks, covering 137 countries from 1995 to 2009. And, using this extensive database, it provides salient facts on trends in foreign ownership, compares foreign and domestic bank characteristics, and analyzes the relationship between foreign bank presence and financial development and the impact of foreign banks on lending stability during the recent crisis.

Before the crisis, the general consensus was that the benefits of foreign banks greatly outweigh costs in many dimensions. Particularly, it was generally considered that foreign banks add to domestic competition, increase access to financial services, enhance financial and economic performance of their borrowers, and bring greater financial stability (Clarke, Cull, Martinez Peria and Sanchez, 2003, Claessens, 2006, Chopra, 2007, and Cull and Martinez Peria, 2011). Generally, lower costs of financial intermediation (measured by margins, spreads, overheads) and lower profitability are documented with greater foreign bank presence (Claessens, Demirguc-Kunt, and Huizinga, 2001 and related studies, e.g., Mian, 2003, Berger, Clarke, Cull, Klapper and Udell, 2005). Also, evidence exists of better quality financial intermediation, e.g., lower loan-loss provisioning with more foreign entry (Martinez-Peria and Mody, 2004). Likely a number of factors are behind these effects of foreign banks, such as the introduction of new, more diverse products, greater use of up-todate technologies, and know-how spillovers (e.g., as people learn new skills from foreign banks, they migrate over time to domestic banks). In addition, foreign banks likely pressured governments to improve regulation and supervision, increase transparency, and more generally catalyze domestic reform (Levine 1996, Dobson, 2005, and Mishkin, 2006).

The effects of the entry of foreign banks on development and efficiency appear to depend though on some conditions. Limited general development and barriers can hinder the effectiveness of foreign banks (Garcia-Herrero and Martinez Peria, 2005; Demirguc-Kunt,Laeven and Levine, 2004). Also, the relative size of foreign banks’ presence seems to matter.

With more limited entry (as a share of the total host banking system), fewer spillovers seem to arise, suggesting some threshold effect (Claessens and Lee, 2003). In terms of individual bank characteristics, it seems that larger foreign banks are associated with greater effects on access to financial services for small and medium-sized enterprises, perhaps as they are more committed to the market, while smaller banks are more niche players (Clarke et al. 2005). Furthermore, the health of both the home and the local host bank operation seem to matter, with healthier banks showing better credit growth (Dages, Goldberg and Kinney, 2000; see also Haber and Musacchio, 2005 and De Haas and Van Lelyveld, 2006).

While the entry of foreign banks is generally thought to have favorable effects on the development of host banking systems, including through increased credit extension, some studies find more ambiguous results. Some show that foreign banks “cherry pick” borrowers (Detragiache, Gupta, and Tressel, 2008; Beck and Martinez Peria, 2007). This can undermine overall access to financial services, since cherry picking worsens the remaining credit pool, and lower financial development, especially in low-income countries where relationship lending is important. Indeed, Detragiache, Tressel and Gupta (2008) show the presence of foreign banks in low-income countries to be associated with less credit being extended. At the same time, a number of studies show that (funding) shocks to parent banks can be transmitted to their foreign subsidiaries with negative consequences for their lending (Peek and Rosengren (1999, 2000); Acharya and Schnabl (2010), Chava and Purnandam (2011); Cetorelli and Goldberg, 2011). Since the onset of the global financial crisis, more studies have also pointed out the risks of foreign banking for financial stability. De Haas, Korniyenko, Loukoianova and Pivovarsk (2011) and Popov and Udell (2010) find for emerging European countries that foreign subsidiaries reduced their lending more compared to domestic banks. De Haas and Van Lelyveld (2011), comparing loan growth of foreign subsidiaries of large multinational banking groups with large domestic banks, find similar results.

Some though find that global banks support their foreign affiliates during times of financial stress through internal capital markets (De Haas and Van Lelyveld, 2006 and 2010; and Barba-Navaretti, Calzolari, Levi and Pozzolo, 2010). Ongena, Peydro Alcalde and Van Horen (2011) find that, while foreign banks reduced lending more than local domestic banks did, they did not compared to domestic banks that had financed their lending boom through borrowing from international capital markets. In addition, De Haas and Van Horen (2011) show that during the global crisis foreign banks continued to lend to those countries that were geographically close and with whom they have established long-term lending relationships, suggesting that foreign banks do differentiate between countries during times of stress.

The crisis also highlighted that, while foreign banks play important roles in the global financial system and affect domestic financial systems, access to financial services, and consequent economic performance, many aspects are not yet well understood, in part due to lack of data. Many studies to date have only used short time periods and a limited number of countries, and hardly any have investigated bilateral ownerships. These three aspects are important to consider, however. A long time period is necessary to properly disentangle effects of cyclical developments and structural changes. A broad spectrum of countries needs to be studied as the causes and effects of foreign bank presence might differ with respect to the importance of foreign banks in the host country or (home and host) development and business and institutional environments. And bilateral patterns need to be studied given the interplay between home and host countries features in entry decisions (Galindo, Micco and Serra 2003, and Claessens and Van Horen, 2010) and between (cultural and institutional) distance and performance (Claessens and Van Horen, 2011).

This paper introduces an extensive database on that contains information on the ownership of 5377 banks in 137 countries from 111 home countries. For each bank, ownership, domestic versus foreign, is determined for each year the bank was active over the period 1995 to 2009, with all changes in ownership (from domestic to foreign and foreign to domestic) and all exits recorded. Important to investigate the factors behind the spread and impact of foreign banks, the home country of the main investor of each bank is identified. Using this database, the paper illustrates salient trends in foreign bank presence over the past two decades. It shows that, albeit interrupted by the global financial crisis, foreign bank presence has increased substantially in most countries, sometimes from none to foreign banks holding 67 percent market share (in terms of numbers) in a single decade. Also many more home countries have become active as investors, with several emerging countries becoming important “exporters.” Substantial differences still exist, though, with foreign bank presence ranging from zero to 100 percent. And foreign ownership is still mostly regional, with this pattern becoming stronger over time.

Taking stock as of end 2007, i.e., just before the crisis, the paper shows that in terms of loans, deposits and profits, foreign banks capture on average about 20 percent of market shares in OECD countries and close to 50 percent in emerging markets and developing countries. Interesting, in those countries with over 50 percent foreign banks in numbers, foreign banks tend to play an important part in financial intermediation. In contrast, when less important in numbers, foreign banks tend to be niche players.

The paper then studies balance sheet and performance characteristics of domestic and foreign banks, and the relationships between foreign bank presence and financial sector development and stability. In terms of balance sheets, the paper finds that foreign banks generally have higher capital adequacy and better liquidity positions. They also engage relatively less in traditional lending businesses. In terms of performance, maybe surprising, foreign banks underperform domestic banks in emerging markets and developing countries, but do not perform differently in high-income countries. Differences reflect in part variations in business strategies between foreign and domestic banks and host country circumstances. Particularly, performance may differ because foreign banks have more conservative portfolios and operate with less ease in some countries than domestic banks do.

In terms of the relations between foreign bank presence and financial sector development, patterns differ by host country. Specifically, in middle-income and high-income countries, foreign bank presence tends to have an insignificant relationship with credit extended. In low-income countries, however, foreign bank presence is associated with less credit extended. In terms of financial stability, we find that foreign banks generally reduced their domestic credit during 2009 more than domestic banks did. Foreign banks did enhance the stability of domestic financial systems though in countries with majority foreign bank presence since their credit growth declined there less than that of domestic banks. The crisis continues to affect banks in many ways. Faced with large losses and capital shortfalls, many banks in advanced countries are undergoing major restructurings, either voluntary or as conditions of government recapitalizations. Furthermore, banks need to comply with stricter regulations, such as Basel III and other measures triggered by the crisis. And all banks are responding to changing global economic patterns, including the economic slowdown in advanced countries and the increased economic importance of emerging markets. While many advanced countries’ banks are less likely to be active investors in the near future, banks from emerging markets, being in much better financial positions, are likely to step into the void, increasing their relative importance as foreign investors, especially within their geographical regions.

The paper itself is structured as follows. Section 2 provides an extensive description of the construction of the database. Section 3 starts with an overview of the main trends in foreign banking. It then reviews the trends in regionalization in foreign bank presence. Section 4 examines the importance of foreign banks in the host country banking system, the balance sheets and performance of foreign banks relative to domestic banks and provides some evidence on the relationship between foreign bank presence and financial sector development. Section 5 studies the impact of foreign bank ownership on lending stability during the global financial crisis. Section 6 discusses the future of foreign banking, including the rising importance of emerging market foreign banks. Section 7 concludes.

IMF. Author/Editor:Claessens, Stijn; Horen, Neeltje van

Foreign Banks: Trends, Impact and Financial Stability

x

Clarity of Central Bank Communication About Inflation

This paper examines whether the clarity of central bank communication about inflation has changed with the economic environment. We use readability statistics and content analysis to study the clarity of communication on the inflation outlook by seven central banks between 1997 and 2010. Overall, we find no strong indications that central banks were less clear in explaining their policies when faced with higher uncertainty or a less favorable inflation outlook. The global financial crisis, however, did have a negative impact on clarity of central bank communication.

This paper studies the clarity of communication by central banks, in particular their communication on the inflation outlook. Communication is an integral element of monetary policy in many developed and emerging economies. Indeed, central banks have made great efforts to increase their transparency and accountability to the public (Eijffinger and Geraats, 2006; Dincer and Eichengreen, 2007). Central banks provide a greater volume of information and communicate through a range of channels – including inflation reports, press releases, and press conferences – and this information tends to be available faster, more frequently, and to wider audiences than ever before. Previous research has identified various benefits of the increase in communication such as higher predictability of interest rate decisions (e.g., Woodford, 2005; Blinder and others, 2008).

Little is known, however, about how clear central banks’ communication is, and what factors drive changes in clarity over time. Recent studies suggest that central banks have not always provided a clear message (Bulíř and others, 2008; Bulíř, Čihák, and Šmídková, forthcoming). In these papers, central banks in a sample of developed and emerging market countries were found to be clear on average between 60 percent and 95 percent of the time. But why have some communications been clear while others are not? Can these variations in clarity be explained? So far, this has not been extensively researched.

Communication clarity and changes therein should be relevant for policymakers, as the quality of communication on the inflation outlook affects the degree to which inflation expectations can be managed. Or, as Blinder (2009) puts it:

“Since clearer communications presumably have higher signal-to-noise ratios, they should in principle convey more information. (…) While the clarity issue has received scant attention in the literature, I find it tantalising that (…) different methodologies come to the same conclusion: that greater clarity enhances the quality of central bank communication. I would love to jump to this conclusion, but it so far rests on a slender evidentiary base. More research on this issue would be welcome.”

Our aim is to fill this gap, that is, to explain variations in the clarity of central bank communication. In particular, does the clarity of central bank communication depend on the context? Is clarity sensitive to the inflation outlook or uncertainty therein, or both?

To motivate why uncertainty in the inflation outlook can influence clarity, imagine writing inflation reports in two different scenarios. The first scenario is straightforward: persistent monetization of debt has resulted in high inflation, and this policy is widely expected to continue. In the second scenario, assume there are many factors, some difficult to measure precisely, and some offsetting each other. On the one hand, there is relatively less to gain from “crafting the message” in the first scenario, because the causes of inflation are obvious and likely to continue; on the other hand, delivering a clear message is relatively easy. In the second economy, the potential gains from a well-crafted message are substantial; however, delivering a clear message is more challenging. In essence, we try to find out whether the communication effort is reflected in additional clarity during complex economic situations.

Our initial hypothesis is that when the inflation outlook is less certain, or less favorable, communication will be more difficult for the central bank, leading to less clarity. More uncertainty is typically associated with more explanatory factors and more challenges when measuring these factors and communicating their impact on the inflation outlook. Admittedly, in situations of greater uncertainty, the clarity of the central bank’s message yields a higher return. The central bank may be well aware that, in some cases, clear explanations are expected. If it then invests more heavily in the drafting process, clarity may well remain unchanged, or it may even increase. We are not aware of research that has sought to investigate this issue empirically.2

It is important to understand the drivers of communication clarity, for two main reasons. First, as argued by Jansen (2011a), clarity is an important pre-condition for transparency. Even if a central bank communicates frequently, but does so opaquely, it can hardly be called transparent. Second, clarity may carry direct benefits. As noted by Blinder (2009), clearer communication has a higher signal-to-noise ratio and carries more information. So far, there has been little work to investigate this hypothesis empirically, but the evidence at hand does suggest that clarity is beneficial. Fracasso, Genberg and Wyplosz (2003) have found that well-written inflation reports are associated with higher predictability of decisions. Jansen (2011b) finds that greater clarity of the Humphrey-Hawkins testimonies by the Fed chairman has gone hand in hand with lower volatility in financial markets.

Our paper makes several contributions to the literature. First, we use a measure for clarity which is standard in many fields, such as linguistics or psychology, but has not often been used by economists. One benefit of this criterion is its objectivity, as it only uses textual characteristics: the number of words, sentences, and syllables. As an alternative measure of clarity, we also use the length of the reports. Second, using this measure, we are able to document how clarity of various types of communications by seven central banks has evolved over the last decade. Third, we analyze if and how clarity has been related to the context in which communications were made. In particular, we study how inflation outlook and the uncertainty around the outlook affected clarity.

To preview our findings, we uncover significant and persistent differences in clarity over time and across countries. Readability appears to be country

While some countries’ inflation reports have become more readable over time (Chile, Sweden, and the United Kingdom), in other countries readability worsened (Thailand).

Regarding our main hypothesis, overall, we find little evidence that central banks were less able to clearly explain their policies when faced with higher uncertainty or a less favorable inflation outlook. Short-term fluctuations in clarity are hard to account for, although the central bank’s assessment of inflation and dissent in voting on interest rates explain some of the variation. Finally, we find that the global financial crisis contributed to making central bank communication less clear. This indicates that—while central bank communication has generally been successful in adapting to new contexts—the financial crisis provided a major communication challenge.

The remainder of the paper is organized as follows. Section II outlines the data and estimation approach. Section III presents results for the clarity of inflation reports, press releases and statements, and report length. Section IV concludes

IMF. Author/Editor:Bulir, Ales; Cihák, Martin; Jansen, David-Jan

Clarity of Central Bank Communication About Inflation

x

International Reserves in Low Income Countries: Have They Served as Buffers?

This paper provides a historical perspective on the role of international reserves in low-income countries as a cushion against large external shocks over the last three decades - including the current global crisis. The results suggest that international reserves have played a role in buffering external shocks, with the resulting macroeconomic costs varying with the nature of the shock, the economy’s structural characteristics, and the level of reserves.

1. This paper is part of the International Monetary Fund’s multi-departmental research project to study reserve adequacy in low income countries (LICs).1 It provides a historical perspective on the role of international reserves as a buffer against large external shocks over the course of the last three decades—including the current global crisis. In particular, the paper seeks to assess whether the macroeconomic costs associated with external shocks were larger in LICs that had lower international reserve holdings prior to a shock event. The following questions are thus addressed: (i) what are the relevant external shock episodes in LICs?; (ii) what are the macroeconomic costs associated with them?; (iii) do such costs vary depending on structural characteristics of the economy, including the level of international reserves?

2. Recent studies on LICs suggest that international reserves may effectively help limit the macroeconomic volatility stemming from exogenous shocks. Though LICs are subject to a wide variety of shocks, it is generally recognized that they are particularly vulnerable to external shocks and natural disasters (Becker et al. 2007). Moreover, the economic costs associated with such shocks are large and seem to vary with the structural characteristics of the economy (Berg et al., 2011). Against this background, international reserves may play an important role in mitigating the impact of shocks and containing macroeconomic volatility (IMF, 2011; Drummond and Dhasmana, 2008).

3. The paper extends previous research on the role of international reserves by examining a wide range of external shocks over the last three decades and by differentiating LICs according to their structural characteristics. For the period 1980–2007, an event-study analysis approach is used to determine the losses in terms of forgone growth of real GDP and consumption per capita associated with different types of shocks (i.e. external-demand, terms-of-trade, climatic, FDI, and aid shocks) and structural characteristics of the economy (i.e. exchange rate regime, export and import concentration, level of indebtedness, and presence of an IMF program). Such losses were then compared across countries with different international reserve holdings in the year prior to the shock episode. For the current crisis period (2008–2010), a four-year event window centered in 2008 was used to assess the impact of the current crisis on several key macroeconomic variables, including real GDP, real per-capita consumption, real p r-capita investment, and external current account.

4. The structure of the paper is as follows. Section II describes the methodology used to identify shock episodes during the period 1980–2007, presents the results of the event study analysis for LICs, and checks for robustness. Section III focuses on the current global crisis (2008–2010). Section IV provides concluding remarks.

IMF.World Bank. Author/Editor:Crispolti, Valerio; Tsibouris, George C.

International Reserves in Low Income Countries: Have They Served as Buffers?

x

Iceland Technical Assistance Report on a New Organic Budget Law IMF

Iceland’s emergence from the 2008 economic crisis presents a unique opportunity to revisit the laws and procedures that shaped fiscal decision-making over the past decade. In the ten years before the crisis, fiscal policy in Iceland was characterized by pro-cyclicality, weak budget discipline, lack of coordination between levels of government, and inadequate surveillance and management of fiscal risks. Many of these shortcomings can be traced back to weaknesses in the legal framework for budgeting. Over the past few years, the exigencies of the crisis have compensated for some of these legal shortcomings and the government has also developed a number of good budgetary practices. However, with the pressures of the crisis abating, there is a need to develop a new organic budget law to preserve fiscal discipline, restore fiscal sustainability, and prevent a reversion to the more permissive

practices of the past.

Iceland’s Ministry of Finance (MoF) has seized this opportunity by establishing a Reference Group comprising the main stakeholders in the budget process to develop a new legal framework for budgeting.1 The Reference Group has been tasked with evaluating the strengths and weakness of the current legal framework and making recommendations on the form and content of a new organic budget law (OBL). The objectives of this new OBL are to:

• Address the gaps, loopholes, and inconsistencies in the current legal framework that contributed to fiscal indiscipline before the crisis;
• Codify the good budget practices that Iceland has developed since the crisis;
• Provide a firm legal foundation for sustainable fiscal policy going forward; and
• Put Iceland at the forefront of international budget practice.

During its two week visit from October 18-31, 2011, the mission held a series of discussions with the Reference Group and other participants in the budget process. This report and its recommendations are an initial contribution to the Group’s ongoing deliberations. In designing a new OBL, it is important to preserve the many good features of Iceland’s current legal framework for budgeting. Iceland’s current organic budget legislation, embodied primarily in the 1997 Financial Reporting Act (FRA):

Is admirably concise and clearly written, with more detailed operational guidance confined to regulations;

Is relatively comprehensive in that it applies not only to the central government’s budget but also to all of the entities and corporations it controls;

Includes a clear categorization of central government institutions for the purposes of financial management and control;

Specifies the required content of key financial documents including the annual budget and final accounts; and

Ensures that both documents are prepared according to the same accounting standards to allow for comparability between plan and outturn.

At the same time, any new OBL should address the key weaknesses in the FRA that prevent it from providing a credible, integrated framework for budgeting. Specifically:

The coverage of the FRA excludes municipalities and their corporations and focuses primarily on ex post financial accounting and reporting;

The law is completely silent on the principles and procedures for macroeconomic forecasting and fiscal policy-making and their link to the annual budget;

The law envisages a relatively unconstrained and fragmented budget formulation process in which the country’s 260 individual agencies (rather than their parent ministries) are the focus of budget discussions;

The budget execution provisions of the FRA include a number of loopholes that enable the government to overspend its budget with relative impunity; and

The FRA’s fiscal reporting provisions were ahead of the standards that existed at the time and are still ahead of most countries’ reporting practices today. However, international accounting standards have moved on and the crisis has revealed the need for more comprehensive and timely information to inform fiscal decisions.

To addresses these weaknesses and reflect the lessons from international experience with budget system laws, Iceland’s new OBL should incorporate the following reforms:

Legal Construction: the institutional coverage of the OBL should be expanded to encompass the whole public sector and incorporate an integrated timetable for the entire budget process—from fiscal policymaking through to end-of-year accounting;

Macro-fiscal Policymaking: the OBL should incorporate a set of fiscal responsibility provisions that oblige each new government to articulate and adhere to a comprehensive, legally binding, and independently monitored fiscal strategy;

Budget Formulation and Approval: the OBL should promote a more disciplined and policy-oriented approach to budget decision-making by reducing the number of appropriations, adopting a top-down sequence to budget preparation and approval, and increasing ministerial responsibility for budget management;

Budget Execution and Treasury Management: the OBL should ensure the annual budget is respected during implementation by tightening the rules around ministries’ rights to retain revenues and carryover past underspends, requiring parliamentary approval of a Supplementary Budget before an appropriation can be exceeded, and establishing a more credible array of sanctions for unauthorized overspending; and

Fiscal Reporting: the OBL should ensure the government is held to account for its fiscal performance by requiring the submission of more comprehensive and timely financial reports that are prepared according to international accounting standards. 

The mission’s specific findings and recommendations in the above areas are summarized in the rest of this section and discussed in detail in the body of this report. A complete list of recommendations is provided in Appendix 1.

This technical assistance report on Iceland was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed in January 2012. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Iceland or the Executive Board of the IMF.

 Published: January 12, 2012.Series: Country Report No. 12/4

Iceland Technical Assistance Report on a New Organic Budget Law IMF

 x

Rwanda IMF Executive Board Completes Third Review Under Policy Support Instrument

Press Release No. 12/4. January 9, 2012.The Executive Board of the International Monetary Fund (IMF) today completed the third review of Rwanda’s economic performance under the Policy Support Instrument (PSI). In completing the review, the Board approved the modification of the end-December 2011 assessment criteria.

The Executive Board approved a three-year PSI for Rwanda on June 16, 2010 (see Press Release No. 10/247). The IMF’s framework for PSIs is designed for low-income countries that may not need IMF financial assistance, but still seek close cooperation with the IMF in preparation and endorsement of their policy frameworks. PSI-supported programs are based on country-owned poverty reduction strategies adopted in a participatory process involving civil society and development partners.

Following the Executive Board’s discussion on Rwanda, Naoyuki Shinohara, Deputy Managing Director and Acting Chair issued the following statement:

“Rwanda’s economy in 2011 is poised for high growth—but also high inflation—with elevated risks for 2012. While strong agricultural output and exports are driving high real gross domestic product (GDP) growth, aggregate demand pressures are also building up and have already pushed up core inflation. Growth is expected to slow in 2012, although risks from an uncertain global economy and further price shocks could bring lower growth and higher inflation. Structural reforms efforts will have to be stepped up to boost growth prospects.

“The authorities have begun to tighten monetary policy in late 2011 to contain inflation. However, further tightening may be needed in 2012 to prevent the erosion of recent gains in macroeconomic stability. Monetary policy implementation is expected to be enhanced further, including by preparing an action plan to develop the interbank money market.

“Fiscal consolidation in FY2011/12 and FY2012/13 remains on track and is expected to further anchor macroeconomic stability. The authorities have introduced additional revenue measures for FY2012/13 to preserve the revenue objective of PSI. The new requirement for State-Owned Enterprises (SOEs) to seek prior approval of the Ministry of Finance before contracting new external debt will help further consolidate recent improvements in Rwanda’s debt management capacity.

“The establishment of a transparent and sustainable institutional structure to supervise Savings and Credit Cooperatives (SACCOs) needs to be fast-tracked. The hiring and training of 60 supervisors was an important first step. Given the speed of rolling out these cooperatives as full-fledged lending institutions, and the risks involved, it is imperative that the necessary institutional structure be put in place without delay.

“In light of significant risks in the global economic environment that could adversely impact Rwanda’s exports and international reserves, the central bank should avoid any further encumbering of the central bank’s foreign assets as collateral for loans to finance the government’s strategic investments,” Mr. Shinohara concluded.

c

IMF Executive Board Completes Third Review Under Policy Support Instrument for Uganda

Press Release No. 12/8.January 13, 2012. The Executive Board of the International Monetary Fund (IMF) today completed the third review under the Policy Support Instrument (PSI) for Uganda. In completing the review, the Board approved a waiver of nonobservance of the ceiling on net credit to government and the modification of quantitative assessment criteria.

The PSI for Uganda was approved on May 12, 2010 (see Press Release No. 10/195) and aims at maintaining macroeconomic stability and alleviating constraints to growth. The IMF's framework for PSIs is designed for low-income countries that may not need, or want, IMF financial assistance, but still seek IMF advice, monitoring and endorsement of their policies. PSIs are voluntary and demand driven (see Public Information Notice No. 05/145).

Following the Executive Board’s discussion on Uganda, Mr. Naoyuki Shinohara, Deputy Managing Director and Acting Chair, stated:

“The Ugandan authorities have appropriately tightened monetary policy to help reverse the acceleration in inflation over the past nine months, in light of increasing evidence that external events have spilled over into underlying domestic inflation. Restrained fiscal policy will support disinflation efforts. The tighter policy stance should facilitate a rebuilding of international reserves and reduce exchange rate volatility. Given higher interest rates and inflation, the Bank of Uganda will also reinforce financial sector supervision.

“Growth is likely to slow in 2012 in light of tighter policies combined with a weaker global growth outlook. However, rapid disinflation is critical to restore the stable macroeconomic environment that has been a necessary foundation for Uganda’s strong and inclusive growth over the past decade.

“Subsidies to the power sector have grown quite large and consume resources urgently needed to implement Uganda’s National Development Plan. The authorities have announced a significant increase in tariffs, which will contain subsidy costs this fiscal year. For the future, they are committed to establishing a system to adjust tariffs automatically in line with changes in underlying costs.

“Over the medium term, the authorities plan to bring their revenue effort in line with other East African countries, mainly by eliminating tax exemptions and incentives. They are also taking steps to put in place a more robust budget management system, including a prudent petroleum revenue management framework”, Mr. Shinohara added.

For information about Projects in Uganda see Eastern Africa Projects

x

IMF Executive Board Completes Seventh and Final Review Under the Extended Credit Facility Arrangement for Burundi and Approves US$ 7.6 Million Disbursement

Press Release No. 12/January 13, 2012.The Executive Board of the International Monetary Fund (IMF) today completed the seventh and final review of Burundi’s economic performance under the economic program supported by the Extended Credit Facility (ECF) arrangement. Completion of the review allows for the final disbursement to Burundi of SDR 5 million (about US$ 7.6 million), bringing total disbursements under the arrangement to an amount equivalent to SDR 51.2 million (about US$ 78.3 million).

The Executive Board also discussed a request by Burundi for a successor three-year arrangement under the Extended Credit Facility (ECF) and expressed general support for such a new arrangement, which would be approved once the existing ECF arrangement expires following the final disbursement thereunder.

The Executive Board approved a three-year arrangement under the ECF on July 7, 2008 (See Press Release No. 08/167). On July 11, 2011, the Board approved an augmentation of access by an amount equivalent to SDR 5.0 million to mitigate the impact of the food and fuel crisis on the balance of payments, and an extension of the ECF arrangement to end-January 2012.

Following the Executive Board discussion on Burundi, Naoyuki Shinohara, Deputy Managing Director and Acting Chair, issued the following statement:

“Burundi has made steady progress in implementing reforms under successive IMF programs in a difficult post-conflict environment. Against the backdrop of rising food and fuel prices and volatile aid flows, performance under the ECF-supported program was satisfactory.

“Stronger revenue mobilization efforts and public financial and debt management policies should continue to underpin fiscal policy. A broader revenue base should help cover the urgent infrastructure needs and increasing social demands, and reduce aid dependency. To safeguard fiscal and debt sustainability in the medium term, the authorities should continue to rely on grants and highly concessional loans.

“While interest rates have risen appropriately in light of the second round effects of the food and fuel prices shock, a further tightening of monetary policy will be necessary to reduce inflationary pressures and to anchor inflation expectations.

“Accelerating structural reforms focused on improving the business and regulatory climate, and reforming the coffee and electricity sectors, will be vital for enhancing Burundi’s growth prospects and reducing poverty and other vulnerabilities”, Mr. Shinohara added.

For more information about Projects in Burundi see Eastern Africa  Projects

c

Kenya Economic and Financial Policies IMF

Despite the severe drought in the arid and semi-arid parts of the country, high food and oil prices, and rapidly deteriorating global conditions, our economy has shown resilience with continued strong growth. We project real GDP growth to remain around 5 percent in FY 2011/12, supported by robust public and private investment. We therefore remain positive on the growth outlook, but we believe that the downside risks have risen, and need to be addressed to preserve and sustain the ongoing expansion in economic activity. Coping with the impact of persistently high international prices, the drought in the Horn of Africa, and the security threats coming from the Somali border, poses formidable challenges to macroeconomic policies.

All quantitative performance criteria and indicative targets for June 2011 have been met. In particular, we have managed to improve our fiscal position, despite the necessary measures taken to protect the vulnerable from high food and fuel prices, and the expenses associated with the implementation of the new constitution. Structural reforms have also moved forward and we are set to meet the benchmark on the submission of the VAT law for the second program review. 

However, since June the increased global market turbulence together with rising inflationary expectations has placed growing pressures on the shilling and on the demand for government securities. As a result, we have not been able to accumulate international reserves as programmed and the government has fully utilized its overdraft facility with the CBK. Therefore, the CBK’s net international reserves (NIRs) have fallen below the September indicative floor, and the CBK’s net domestic assets (NDAs) have risen above the September indicative ceiling.

Since the program first review, the country’s macroeconomic outlook has worsened with respect to inflation and the external position:

Inflation has intensified and reached levels that could threaten the economic expansion. First-round effects from the increased food and fuel prices have fed into core inflation because of strong domestic demand fueled by the rapid growth in credit to the private sector.

The country’s external position has deteriorated not only because of higher than originally expected international prices and drought-related import needs but also because of the strength of domestic demand.

The shilling’s exchange rate has depreciated substantially in response to a widening current account deficit. The shilling’s slide has added immediate pressures on domestic prices that, if not addressed, could feed back on the external position and the exchange rate raising the risk of destabilizing macroeconomic conditions. To address this risk and protect the ongoing economic expansion we intend to promptly adjust our macroeconomic policy stance by:

Further tightening monetary policy as needed to stem inflationary expectations; and Cutting back on non-priority government spending to contribute to lower domestic demand and mitigate the impact of monetary tightening on market interest rates.

We remain committed to a policy regime free from controls on prices, interest rates, and the exchange rate. We are convinced that price controls do not work, may be detrimental to economic activity, reduce access to essential goods, and hurt the poor most.

Letter of Intent, Memorandum of Economic and Financial Policies, and Updated Technical Memorandum of Understanding. 

For more information about Projects in Kenya see Eastern Africa Projects

x

Mali Seventh Review Under the Extended Credit Facility and Request for a new Three-Year Arrangement Under the Extended Credit Facility-Staff Report

The discussions were held in Bamako during September 5–16, 2011, and continued in Washington during September 23–26. The staff team comprised of Mr. Josz (head), Ms. Farahbaksh, and Messrs. Hitaj (all AFR), Nguenang (FAD), Féler (resident representative) and Traoré (local economist). Mr. Belhocine (FAD) participated in the discussions held in Washington. The team met with the Prime Minister, the Minister of Finance and Economy, the Deputy Minister in charge of the Budget, the National Director of the regional central bank (BCEAO), as well as well as representatives from the private sector, trade unions, civil society, and the donor community.

ECF arrangement. The three-year arrangement under the Extended Credit Facility (ECF) was approved on May 28, 2008, in the amount equivalent to SDR 27.99 million (30 percent of quota). The fifth review was completed on January 26, 2011, when the arrangement was extended until end-December 2011. The sixth review was completed on June 13, 2011, when its access was augmented by SDR 25 million (27 percent of quota). The authorities are requesting the eighth and last disbursement under the arrangement (SDR 6 million).

Successor ECF. In the attached Letter of Intent (LOI) and Memorandum of Economic and Financial Policies (MEFP), the authorities are requesting approval of a successor three-year arrangement under the ECF, in the amount equivalent to SDR 30 million (32 percent of quota) in support of their new strategy to increase growth and reduce poverty, and the first disbursement under the new arrangement (SDR 6 million).

Staff views. Based on the strong program implementation and the authorities’ policy intentions, the staff recommends completion of the seventh review of the current ECF arrangement and approval of the authorities’ request for a new three-year ECF arrangement.

Published: January 04, 2012. Series: Country Report No. 12/3. Joint IDA/IMF Debt Sustainability Analysis; Informational Annex; Statement by IMF Staff Representative; Statement by Alternate Executive Director for Mali; and Press Releases

Mali Seventh Review Under the Extended Credit Facility and Request for a new Three-Year Arrangement Under the Extended Credit Facility-Staff Report

For more information about Mali see Proyects Western Africa

c