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IMFSurvey Magazine: Policy

Changing currency in Kuala Lumpur, Malaysia—one of 30 economies the IEO studied in depth (photo: Bazuki Muhammad/Reuters).

IMF Surveillance

IMF Exchange Rate Advice In Spotlight

By Lynn Aylward
IMF Policy Development and Review Department

May 17, 2007

  • IMF putting greater emphasis on exchange rate analysis
  • Globalization propelling exchange rate issues to the fore
  • Several IMF initiatives under way to strengthen exchange rate advice

The emergence in recent years of large global imbalances and changes in global trading patterns have propelled exchange rates and related policies to the heart of the public debate in many countries.

Accusations of unfair currency practices are being waved at a number of countries with large trade surpluses, and calls for defensive measures are heard in some countries running large deficits, whether in the form of trade protectionism or of exchange rate policies. This has brought back in the spotlight a key mandate of the IMF, namely exchange rate surveillance—the focus of a new report by the IMF's External Evaluation Office (IEO) that assesses the Fund's advice in this critical area.

Enhancing the IMF's work in this area is a key component of the Medium-Term Strategy (MTS)—Managing Director Rodrigo de Rato's strategic plan for enhancing the IMF's relevance and effectiveness in the 21st century. Under the MTS, a number of initiatives aim to ensure that exchange rate surveillance is as clear, candid, technically expert, and influential as it can be.

Part of original mandate

Since the IMF's creation, it has been closely involved in exchange rate matters. Indeed, one of the main reasons for establishing the IMF and putting it in charge of the Bretton Woods system was to promote dialogue and cooperation among countries so as to rebuild international trade and finance. The founders understood that the alternative could be a return to the vicious cycle of competitive depreciation and protectionism that contributed to the turmoil of the 1930s.

The current role of the IMF's exchange rate surveillance—or of surveillance more generally—is to assess how countries' policies fare in light of the commitments they undertake as members of the IMF. More specifically, the IMF assesses the impact of countries' exchange rate and other policies on their external stability and, hence, on the stability of the international system of exchange rates.

The goal is to support policies that are good for the member but also good for other countries through a process of collaboration, in which dialogue and persuasion are key. In the global economy, one country's policies can have powerful ripple effects on other countries, and the case for such collaboration is therefore arguably even stronger than in 1944.

"The IMF's country reports, which analyze economic developments and describe policy discussions between member countries and IMF staff, are the main channel for surveillance."

Float or peg?

Under Article IV of the IMF's Articles of Agreement, which sets out the foundations of surveillance, members are largely free to choose their own exchange rate regime (for example, whether to float or peg). However, they are committed to collaborate with the IMF to promote a stable system of exchange rates, follow exchange rate policies compatible with this undertaking, and avoid manipulating exchange rates in order to prevent an effective balance of payments adjustment or to gain an unfair competitive advantage over other countries.

Further guidance adopted by the IMF (in the landmark 1977 Decision on Surveillance over Exchange Rate Policies) stipulates that members should intervene in the exchange market if it becomes necessary to counter disorderly conditions and that they should take into account the interests of other member countries in their exchange intervention policies.

Countries with a freely floating exchange rate, which do not have exchange rate policies per se, are subject to surveillance all the same with respect to their domestic policies. Indeed, all members are committed to managing their domestic policies in a way that fosters domestic stability because unstable domestic conditions can cause severe disturbances to external stability.

Exchange rate surveillance in practice

The IMF's country reports, which analyze economic developments and describe policy discussions between member countries and IMF staff, are the main channel for surveillance. In these reports, which are prepared annually for most of the Fund's 185 members, IMF staff are expected to provide an accurate description of the country's exchange rate regime (whether the currency is floating, pegged, or fixed), a candid appraisal of the regime's appropriateness and consistency with underlying policies, and a forthright assessment of the exchange rate level (the currency's value compared to other currencies) through the systematic use of a broad range of indicators and analytical tools to evaluate external competitiveness.

IMF staff are also expected to assess policy spillovers, including those operating through exchange rate policies, and to describe the policy dialogue they had with government officials from the central bank, finance ministry, and with other stakeholders. In performing this task, IMF staff face longstanding challenges, reflecting a combination of technical uncertainties and political sensitivities.

Technical uncertainties

The technical uncertainties arise because many questions in exchange rate economics remain unsettled, including what constitutes the "right" exchange rate regime or the optimal level of international reserves for a given country at a given time. Assessments of exchange rate levels are also often subject to large margins of uncertainty.

To address these challenges, the IMF strives to stay at the forefront of research on exchange rates. IMF staff are engaged in an active research program, including in such new areas as defining what constitutes an optimal level of international reserves. For the past few years, the IMF has on average issued over 30 working papers a year on exchange rate-related issues.

Data availability is also a problem in many countries. Data availability issues are often discussed in country reports, and the IMF provides technical assistance in this area to countries that request it.

Another challenge confronting the IMF is that exchange rate policy can be politically controversial as well as market-sensitive. This can constrain the depth and candor of the dialogue between the IMF and its members. It can also affect the reporting in documents that are subsequently published. To mitigate this risk and preserve the IMF's ability to serve as a trusted advisor to its members, its transparency policy includes safeguards to maintain the appropriate balance between transparency and confidentiality. This policy allows for deletions of highly market-sensitive material in country reports before they are made public.

Strengthening exchange rate surveillance

A cornerstone of the MTS is that the IMF must give more emphasis to exchange rate surveillance. A critical initiative under way in this connection is the updating of the policy framework for exchange rate surveillance, most prominently through a review of the 1977 Surveillance Decision. An updated decision would encourage best practice in surveillance by clarifying the membership's expectations on the proper scope and conduct of surveillance. It is also an opportunity to reflect the changes that have taken place in the world economy since 1977, in particular the emergence of globalized financial markets.

Much work is also under way to strengthen the analytical underpinnings of exchange rate surveillance. In particular, the IMF's Consultative Group on Exchange Rates (CGER), which relies on cutting edge methodologies for assessing exchange rate levels, has recently expanded its coverage from industrial countries to include all major emerging market currencies. A further broadening of this coverage is now envisaged.

Best practices

The IMF is also disseminating more of its knowledge and best practices. A book collecting the best exchange rate analysis at the IMF is under preparation, and the institution's 2007 annual research conference will focus on exchange rate policies. Training of IMF staff on exchange rate issues has increased. Recent efforts have also focused on better integrating exchange rate surveillance with analysis of financial sector issues and a deeper examination of cross-country spillovers.

Finally, the IMF is enhancing its internal monitoring of the quality of exchange rate surveillance. As demonstrated by a stocktaking earlier this year, all these efforts are gradually bearing fruit. The IMF considers its recent country report on China one example among many others of good practice in terms of exchange rate surveillance (see "Getting It Right").

As noted, many initiatives to improve the IMF's exchange rate policy advice are already under way as part of its MTS. Over the next few months, the IMF's Executive Board will consider specific proposals on how to follow up on the IEO's recommendations.


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