from Follow the Money

Has the IMF been asleep at the wheel, and ignored surveillance of exchange rates?

September 29, 2005

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Tim Adams - the new US Treasury Under Secretary - thinks so: 

IMF Article IV requires that the IMF exercise "firm surveillance" over the exchange rate policies of members. After the collapse of the Bretton Woods fixed exchange rate system, the IMF in 1977 developed surveillance guidelines that determine its approach to what is still called the "Article IV" process. Those guidelines included domestic policies, since domestic policies can impact a country's balance of payments position.

Over time, however, domestic policies have come to dominate Article IV reviews, and it is not uncommon to read an Article IV review with only a brief reference to a member's exchange rate policy and its consistency with both domestic policies and the international system. There is almost never discussion of whether an alternative regime could be more appropriate or how to transition to it.

Many large emerging-market countries would benefit from regimes that allow substantial exchange rate flexibility. Research, including by the IMF, has shown that for developing countries integrating into international capital markets, the requirements for sustaining pegged exchange rate regimes have become very demanding.

The IMF also has standing authority to initiate "special consultations" whenever one member's exchange rate policy is having an important impact on another member. However, in over a quarter century, the IMF has held special consultations exactly twice. This has placed increased pressure on bilateral mechanisms and actions to address instances of protracted currency misalignment.

We understand that tough exchange rate surveillance is politically difficult for the IMF. It is also true that a country has the right to determine its own exchange rate regime. Nevertheless, the perception that the IMF is asleep at the wheel on its most fundamental responsibility—exchange rate surveillance—is very unhealthy for the institution and the international monetary system.
  (emphasis added)

I am not exactly a fan of the Bush Administration's economic policy, but on this, I agree with Tim Adams and the Treasury.  The IMF did not call out countries with overvalued exchange rates in the 1990s -- in 2000 and 2001, with the support of the US, it even financed a country with an overvalued exchange rate.  And it has refused to call out countries that are engaging in massive, sustained intervention to maintain undervalued exchange rates now. 

The IMF remains far more willing to criticize countries with inappropriate fiscal policies (the US) than to criticize countries that are intervening heavily to maintain inappropriate exchange rates (China, Malaysia, many oil exporters who peg to the dollar).

It does not make sense for countries with large current account surpluses to tie their currencies tightly to the currency of the world's largest debtor.  But that is not the only problem. Many of these countries have pegged their currencies to the dollar at exchange rates that made sense in 1998 -- when the dollar was strong, oil was under $20, and China had a much smaller and much less productive capital stock --  but not in 2005.

In theory, the IMF's surveillance (surveillance is a nasty-sounding world for the IMF's annual check up on countries' economic policies) is supposed to focus on exchange rate policies.  After all, exchange rate regimes and exchange rates are the core of the international monetary and financial system, and the IMF is supposed to help make the international monetary system work as it should.   In practice, the IMF often ignores exchange rate policies, and instead focuses on domestic policies -- typically fiscal policy.  

The IMF's unwillingness to focus on exchange rates is not a new.  The IMF ignored the problems created by Argentina's dollar peg and the resulting strong peso policy - which linked a sinking Argentine economy to a rising US economy and a rising dollar back in the late 90s.   The problem was not just that Argentina's monetary and fiscal policies were inconsistent with Argentina's exchange rate policies.   That is an easy thing for the IMF to say - if you are willing to contract your economy enough with tight monetary and fiscal policies, and thus bring about enough deflation, a country can squeeze itself into any exchange rate.  The problem was that Argentina's exchange rate policies were inconsistent with growth in Argentina, since the needed adjustment could only come about through deflation.   The IMF never said that.

And right now, the IMF has been unwilling to go beyond general calls for greater exchange rate flexibility in Asia.  It has not been willing to signal forthrightly that China's exchange rate is undervalued. 

The IMF's Articles call on every country to "avoid manipulating exchange rates or the international monetary system to prevent effective balance of payments adjustment or to gain unfair competitive advantage over member countries."  It is pretty clear at least to me that China's de facto peg is an impediment to effective balance of payments adjustment.

The evidence?  Look at some of the data in the IMF's report on the Asian-Pacific region.    Emerging Asia is more dependent on oil than any other major part of the world economy, and thus more exposed to an oil price shock.   Higher oil prices therefore should lower its current account surplus.    Has that happened?  No - not in aggregate.  Some countries are moving from surplus to deficit, or seeing their surpluses shrink.  But not China.    And as a result, the region as a whole is maintaining a constant current account surplus despite paying a lot more for oil. 

The path of China's non-oil current account surplus is revealing:

  • 03: 4.7 % of GDP
  • 04: 6.5 % of GDP
  • 05: 9.6 % of GDP (estimate)
  • 06: 9.7 % of GDP (estimate) 

The rapid increase in China's non-oil surplus shifts the global burden of adjustment for higher oil prices onto others.  China's oil imports are forecast to rise from 1.5% of its GDP in 2003 to 4.1% of its GDP in 2006.   Put differently,  if China's non-oil current account surplus stayed constant at its 2003 level, China's current account surplus in 06 would be forecast to be around 2% of its GDP - and the world would be a far different place.   And to be honest, I suspect the IMF's 05 and 06 forecasts for China's non-oil current account surplus are more likely to prove to be too low than too high.

The same basic story holds for Malaysia.  It is an oil exporter, and its oil related surplus is rising.  But its non-oil surplus also has stayed above 11% of GDP since 2003.   That is kind of high.  One would expect higher oil revenues to generate spending on non-oil imports and thus significantly lower the non-oil surplus. 

Those large non-oil current account surpluses are an impediment to global adjustment.  They imply that the growing surpluses of the oil exporters will be offset by growing deficits in countries that already have deficits - i.e. the United States.

But, you may say, Chinese wages are so low that its exchange rate is basically irrelevant.    Not true.  My evidence.  Look at what has happened to China's trade with Europe since 2002, when China decided to allow the RMB to fall against most European currencies along with the dollar.   Its trade with Europe shifted from rough balance to a major surplus, largely because Chinese exports to Europe absolutely surged.  That looks like a response to the moves in the exchange rate to me. 

But you might ask, doesn't every country have the right, according to the IMF charter, to select its own exchange rate regime.  Certainly.  But that does not give it the right to hold to whatever exchange rate it likes without being subject to international criticism.   I'll turn the microphone over to Morris Goldstein.

IMF members are free to pick fixed rates, floating rates or practically any currency regime in between.  They are permitted to intervene in exchange market and indeed are expected to do so when they encounter disorderly market conditions.  But what is not permitted under IMF rules is to engage in a particular kind of intervention - namely large scale, protracted, one-way intervention.  ....  China can thus legitimately maintain that its choice of currency regime - be it a fixed rate or a managed float - is a matter of national sovereignty.  But it cannot legitimately maintain that it alone gets to decide as a sovereign matter what the exchange rate between the RMB and the dollar should be (within that currency regime) for long periods of time regardless of economic signals about whether that rate is or is not an equilibrium rate - any more than the United States gets to decide unilaterally what the dollar-RMB rate should be.

Much of the recent strain associated with globalization can be linked to China's steadfast defense of its dollar peg, and its current policy of spending $300 billion, a bit over 15% of its GDP, to resist RMB appreciation.   That has consequences.

Among other things, it puts more pressure on the US manufacturing sector.  It almost certainly reduces overall employment in the manufacturing sector.  But it also has other consequences.  It helps keep US interest rates low, and that supports employment in the housing sector.  China may not impact on overall employment in the US, but it certainly has an impact on the composition of employment. 

If the Fund does not take multilateral exchange rate surveillance seriously, the US will no doubt eventually opt for what might termed unilateral exchange rate surveillance - and I don't think that is a good thing.

De Rato and the Fund claim that US concerns about exchange rate manipulation reflect domestic political pressure.  No doubt true.  But that does not mean the basic argument made by the US lacks merit.   In this case, domestic political pressure is emerging precisely because some countries are standing in the way of global adjustment.   That helps some sectors in the US, but hurts others. 

Of course, publicly criticizing China's defense of its current exchange rate won't be easy.  China is underrepresented in the Fund now, and would be even more unrepresented if its economy was valued using a more realistic exchange rate.  But it could well be the Fund's largest shareholder at some point in the future.  And it does not take kindly to external criticism, no matter how well deserved.   The Fund would rather not get involved in dispute between the US and China.

But it is hard to see how the Fund can do its job if it is not willing to take a more active role, no matter what the political risks.  I agree with Michel Camdessus:

Let me enter a plea for the fund to take a bold initiative in this area," said Michel Camdessus, a former IMF managing director, in a lecture Sunday attended by many top economic policymakers. Recalling the coordinated agreements during the mid-1980s among the major industrial powers that helped deal with the global economic stresses of that era, Camdessus said: "Now is the time for a similar effort, led this time by the IMF . . . because there is no other -- I insist, no other -- legitimate, global forum to tackle such a systemic problem.

Camdessus quote comes from this Paul Blustein article.

But so long as the Fund refuses to weigh in more forcefully on China's peg as well as on US fiscal policy, its influence will fall.  China and the US will resolve their differences bilaterally.  And I suspect the risks of a bad outcome for the global economy - risks David Wessel wrote about on Thursday -- will continue to rise.

Of course the US is taking a risk by pushing on the Fund to push on China too.   There is a small chance China might actually listen to the US, and agree to make real changes to its exchange rate regime -- changes that reduced the pace of growth in China's reserves.

China's defense of its current exchange rate is an impediment to global adjustment.   But if the US government continues to run large deficits and US households continue not to save, it is not clear that the US really wants global adjustment -- since REAL global adjustment would make it harder for the US to import global savings to make up for a lack of domestic saving.   

There is a reason why debtors usually are NOT at the forefront of calls for adjustment.

The United States' overall policy certainly seems inconsistent. 

On one hand, the US wants China and others to let their exchange rates appreciate, which means that they will intervene less and thus have fewer dollars to invest in US treasuries.

On the other hand, the US government intends to borrow a ton of money ($100 b, $200 b) to rebuild New Orleans and the Gulf Coast, pushing the US deficit up. 

If China and others followed the US government's advice, the world's central banks were scaling back their reserve buildup, and thus buying fewer bonds, just when the US needs to sell more bonds to borrow the funds needed to rebuild.

According to the US, that is not much of a worry, since foreign central banks have not played a major role keeping US interest rates down. 

I am not so sure.  Nor is the Banque de France.  Nor for that matter are Francis and Veronica Warnock of the Fed staff.

Warnock's study looks at overall foreign demand for US debt, not central bank demand.  But since the US data on direct central bank buying has lots of problems, and those problems are getting worse, his data is still illustrative.  Moreover if central banks build up their offshore dollar bank accounts, they are indirectly financing a lot of private foreign demand.  London hedge funds borrow dollars in the offshore market (effectively borrowing the central banks dollar reserves) and use the dollars to make fancy bets on various US fixed income markets.

As US short-term rates rise and US fiscal policy turns expansionist, the dollar is rallying.  Market participants are noting that the current policy mix (sort of) resembles the tight money/ loose fiscal mix that generated the strong dollar in the early 80s.   Fair enough.  Monetary policy is at least tighter than in the loose money/ loose fiscal 02-03 period.  But prior to the period of dollar strength in the early 1980s, the US did not have a large trade deficit.  That is - to put it mildly - not the case now.  Those going massively long dollars right now in the expectation of a repeat of the early 80s are taking something of a risk.  Barring a big, sustained slowdown in US consumer spending (not inconceivable, given today's data, but also not dollar supportive), the US trade and current account deficits looks set to rise well above 7% of GDP next year.   That would worry me -- though it does not seem to worry many currency traders right now.

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