Exchange rate display in Tokyo, Japan: IMF decision includes clear guidance on exchange rate policies (photo: Issei Kato/Reuters)
SURVEILLANCE GUIDELINES
Managing Director Rodrigo de Rato, speaking in Montreal at the International Economic Forum of the Americas conference on June 18, said that the decision is "the first major revision in the surveillance framework in some 30 years, and it is the first-ever comprehensive policy statement on surveillance." He added that it is "good news for the IMF reform program and good news for the cause of multilateralism."
The adoption of the Decision on Bilateral Surveillance eliminates a significant gap in the IMF's policy framework by providing an up-to-date and more comprehensive framework for the regular "health checks" of national economies—a process that complements the IMF's oversight of the international monetary system (known as "multilateral surveillance").
The landmark step was announced as the IMF moves swiftly on many fronts to better meet the demands of a more integrated world economy such as by giving more dynamic economies—many of which are emerging markets—a bigger say in the institution, reforming its sources of income, sharpening the focus of its work on low-income countries, and reexamining its tools to support emerging markets.
Exchange rate policies
It also comes at a time when accusations of unfair currency practices are being waved at a number of countries with large trade surpluses, and calls for defensive measures—whether in the form of trade protectionism or of exchange rate policies—are heard in some countries running large deficits.
By crystallizing a shared vision of what surveillance is all about, the new decision should ensure that the policy dialogue between the Fund and its member countries is more focused and more effective. Changes are most notable in three areas.
• First, the new decision affirms that bilateral surveillance should be focused on the IMF's core mandate, namely promoting countries' external stability, and should thus help prevent surveillance from being spread too thin.
• Second, it gives clear guidance to the Fund's members on how they should run their exchange rate policies and on what is and is not acceptable to the international community. For the first time, the meaning of exchange rate manipulation is spelled out.
• Third, by making clear what is expected of surveillance, the decision should promote candor as well as evenhanded treatment of different countries.
Why new decision was needed
Until now, the main policy statement on IMF surveillance was the 1977 Decision on Surveillance over Exchange Rate Policies, which was crafted in the wake of the collapse of the Bretton Woods system of par values. At the time, uncertainty prevailed about the rules of the game—whether they related to the role of the Fund or to macroeconomic management without fixed exchange rates—and private capital flows played a more limited role.
Box 1
What is external stability?
IMF surveillance aims at fostering stability in the international monetary system by encouraging national policies that do not disrupt or compromise external stability. Here, the interest is in both the balance of payments stability of the country and the effect of its balance of payments position on the stability of other countries' balance of payments.
External stability has been achieved when the balance of payments position does not, and is not likely to, give rise to disruptive adjustments in exchange rates. This requires both (i) an underlying current account (that is, the current account stripped of temporary factors, such as cyclical fluctuations, temporary shocks, and adjustment lags) broadly in equilibrium—a situation in which the country's net external asset position is evolving consistently with the economy's structure and fundamentals; and (ii) a capital and financial account that does not create risks of abrupt shifts in capital flows, whether through the presence of financing constraints or the buildup or maintenance of vulnerable external balance sheet structures.
When the underlying current account is not in equilibrium (which may be due to exchange rate policies but also to unsustainable domestic policies or to market imperfections), the exchange rate is "fundamentally misaligned." In other words, fundamental exchange rate misalignment, an important indicator of external instability under the 2007 decision, is a deviation of the real effective exchange rate from its equilibrium level—that is, the level consistent with a current account (stripped of cyclical and other temporary factors) in line with economic fundamentals.
While the concept is clear, it is subject to significant measurement uncertainties. Accordingly, the IMF will exercise appropriate caution in reaching conclusions about misalignments. Moreover, in practice an exchange rate would only be judged to be fundamentally misaligned if the misalignment was significant.
The expectation was that the decision would be revised with experience. In the event, while the practice of surveillance evolved, the decision itself remained virtually unchanged. As a result, a huge disconnect developed between the best practice of surveillance and the decision that purportedly supported it.
In addition, the principles included in the 1977 decision to provide guidance to member countries on the conduct of their exchange rate policies failed to address the developments that have most challenged the stability of the international monetary system over the past 30 years. Reflecting the key concerns of the period when they were drawn up, the principles focused on preventing exchange rate manipulation for balance of payments purposes, such as gaining an unfair competitive advantage, and on avoiding short-term exchange rate volatility.
By contrast, the most prevalent exchange rate-related problems since 1977 have been the maintenance of undervalued or overvalued exchange rate pegs for domestic reasons and, more recently, capital account vulnerabilities often arising from domestic balance sheet imbalances.
Changes for IMF
Like the 1977 decision, the 2007 decision is designed to implement bilateral surveillance under Article IV of the IMF's Articles of Agreement, under which members of the IMF commit to a code of conduct on exchange rate policies and domestic economic and financial policies. The IMF has a duty to monitor adherence to this code of conduct as a whole; however, the 1977 decision covered only surveillance over exchange rate policies.
The new decision, by contrast, is much broader. It clarifies that the scope of bilateral surveillance covers all policies that can affect a country's external stability—where external stability consists of a balance of payments position that does not, and is not likely to, give rise to disruptive exchange rate movements, and encompasses both current and capital accounts (see Box 1).
The decision also clarifies how to implement surveillance in currency unions, given their specific institutional arrangements, with both union-level and individual members' policies subject to the same scrutiny as the policies of all Fund members. These clarifications should help sharpen the focus of surveillance.
The new decision also outlines the rules of the game for surveillance:
• Surveillance is a collaborative process, based on dialogue and persuasion.
• The effectiveness of this dialogue requires candor: the IMF must be prepared to deliver clear and sometimes difficult policy messages to members and to candidly inform the international community represented by the IMF's membership.
• Surveillance must be evenhanded, while also paying due regard to relevant country circumstances. In particular, surveillance should take account of the effects of recommended policy changes on the member government's objectives besides external stability.
Box 2
What is currency manipulation?
The IMF's Articles of Agreement provide that member countries shall "avoid manipulating exchange rates ... to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members." But the Fund had provided little guidance on what constitutes such exchange rate manipulation. The 2007 Decision on Bilateral Surveillance that the IMF's Executive Board approved on June 15 provides guidance to the IMF's 185 member countries on the type of behavior that is at issue.
The 2007 decision provides that a member would be "acting inconsistently with Article IV, Section 1 (iii)," if the Fund determined it was both engaging in policies that are targeted at—and actually affect—the level of exchange rate, which could mean either causing the exchange rate to move or preventing it from moving; and doing so "for the purpose of securing fundamental exchange rate misalignment in the form of an undervalued exchange rate" in order "to increase net exports."
• Bilateral surveillance should be embedded in a multilateral perspective—that is, it should take into account spillovers from the global environment to a country and from a country's policies to the stability of the international monetary system.
• Surveillance should take a medium-term view.
Changes for member countries
As for members, the new decision gives clearer guidance on how they should run their exchange rate policies and on what is and is not acceptable to the international community. The decision retains the three existing principles, which relate to exchange rate manipulation and intervention in the foreign exchange markets.
But it adds a fourth principle: "A member should avoid exchange rate policies that result in external instability," which focuses on the outcome of the policies at issue rather than their intent. And it elaborates on what is meant by exchange rate manipulation (see Box 2).
How about what would trigger a thorough review by the IMF and might indicate the need for the IMF to initiate discussion with a member about its observance of the principles? The existing indicators have been updated, especially to reflect the greater importance of international capital flows.
The indicators now include both policy developments (such as protracted large-scale intervention in one direction in the exchange market) and outcomes (such as fundamental exchange rate misalignment; large and prolonged current account deficits or surpluses; and large external sector vulnerabilities, including liquidity risks, arising from private capital flows).
