Currency dealers in Mumbai, India: Today, many countries have adopted flexible exchange rates (photo: Savita Kirloskar/Reuters)
STRENGTHENING IMF SURVEILLANCE
They all influence exchange rates in today's complex world of open borders and freely moving capital. When the IMF was created more than 60 years ago, it was given the mandate to promote exchange rate stability. But back then, exchange rates were fixed and backed by gold.
Today, many countries have adopted flexible exchange rates, letting the markets determine the price of their currencies. Other countries operate various forms of pegged regimes and intervene by buying or selling currency to target a particular exchange rate.
The IMF gives its member countries advice on how to manage their exchange rates through a policy dialogue known as surveillance. In recent years, there have been many calls for the Fund to get tough on countries that are perceived to be manipulating their currencies to gain an unfair trading advantage.
But giving countries firm guidance on how to manage their exchange rates is far from straightforward. First, there is no widely agreed economic theory to analyze many exchange rate issues. Second, the IMF's charter—known as the Articles of Agreement—gives countries pretty wide latitude in choosing their preferred exchange rate regime. And, beyond the power of persuasion—and invoking a rarely used option known as "supplemental consultations"—there is little the IMF can do to effect change in countries' policies.
As part of his medium-term strategy for modernizing the IMF, Managing Director Rodrigo de Rato asked his staff to approach this dilemma on two fronts. First, by coming up with a proposal to modernize the IMF's surveillance mandate—known as the 1977 decision—as a way of clarifying the institution's role in advising countries, not just on exchange rates, but on other aspects of economic policy as well. And second, by seeking to improve the IMF's analytical toolkit for analyzing exchange rates.
Reality check
The IMF carries out exchange rate analysis on two levels: the bilateral level and the multilateral level (see Figure 1). Both these levels feed into each other. The multilateral exchange rate assessments provide a useful reality check for the bilateral assessments. This is because bilateral assessments of exchange rates need to add up—if one country's currency is deemed overvalued, some other country's currency has to be deemed undervalued—and the only way to ensure this is by imposing a multilateral consistency constraint.
As an important step toward strengthening the IMF's analytical framework for exchange rate analysis, the IMF's Research Department published a paper in October 2006 outlining a new methodology for assessing the consistency of exchange rates with medium-term fundamentals, within a multilaterally consistent setup. The approach is known within the IMF as "CGER"—short for the Consultative Group on Exchange Rate Issues—because it was pioneered by staff from different departments within the IMF in the 1990s.
The CGER's original mandate was to focus on industrial countries. But with the growing weight of emerging market countries in the global economy, there was a clear need to integrate the key emerging market countries into the CGER exercise. This necessitated a revision of the methodology, given the very different economic conditions in advanced and emerging market countries. Three complementary approaches now underpin the CGER's approach to assessing the consistency of exchange rates with medium-term fundamentals. They are
• the macroeconomic balance approach, which calculates the difference between the current account balance projected over the medium term at prevailing exchange rates and an estimated equilibrium current account balance;
• the reduced-form equilibrium real exchange rate approach, which estimates an equilibrium real exchange rate for each country as a function of medium-term fundamentals, such as the net foreign asset position of the country, productivity growth in the tradables and nontradables sectors, and the terms of trade; and
• the external sustainability approach, which calculates the difference between the actual current account balance and the balance that would stabilize the net foreign asset position of the country at some benchmark level.
The complementarities among these three approaches helps to establish whether the underlying results are robust. The three methods focus on different aspects: flow quantities, stock quantities, and relative prices. So when they point in a similar direction, they provide a powerful signal that economically relevant aspects of exchange rate misalignment are being captured. This, in turn, should lead to more balanced judgments about how currencies may need to adjust as present global imbalances are unwound.
