Speech

95/16 Managing Director of the International Monetary Fund
at the Japan Center for International Finance (JCIF)
Tokyo, October 23, 1995

---

Ladies and gentlemen, it is a pleasure to join this distinguished group in discussing the stability of foreign exchange rates and the international monetary system. It is particularly pleasing to be in the company of Mr. Takeshita, Governor Matsushita, and several other fellow veterans of the Plaza meeting. I would like to thank our hosts at the Japan Center for International Finance for providing this opportunity, and for inviting us, to reflect further on these important issues ten years after the Plaza Agreement!

In addressing you, I have in mind not only the Plaza meeting (which is particularly memorable), but also all the G-7 meetings that I have attended since joining the IMF in 1987. It is from this dual perspective that I would like to share with you my views on what was achieved through the Plaza Agreement, what has become of international policy coordination since then, and what I believe we should strive for now.

Let me begin with the Plaza Agreement. Although there were many things that the Plaza Agreement did not achieve, it was successful in two important respects: one, in helping to convince the market that exchange rates--and in particular, the value of the U.S. dollar--were not consistent with economic fundamentals and that the G-5, and particularly the U.S., were determined to correct this misalignment; and two, in contributing to an orderly adjustment of exchange rates--the much hoped for "soft landing" of the dollar. For this, the Plaza Agreement is rightfully seen as a landmark in G-7 policy coordination.

It must be acknowledged, however, that the Plaza Agreement was reached in particularly propitious circumstances. First, there was a clearly identifiable--and widely recognized--threat to the international economy: by late 1984 and early 1985, the value of the dollar was obviously unsustainable, and there was a substantial risk that the inevitable correction would be disorderly. Concern about the high and rising dollar was based partly on widening external imbalances, especially the U.S. deficit and the Japanese and German surpluses, mounting protectionist sentiment in the United States, and inflationary pressures in other countries. Second, in view of the strains that these problems placed on each of the G-5 countries, each had a strong common interest in tackling the "dollar problem."

Third, there was a recognition among the G-5 of their economic interdependence. As a result, there was a greater willingness on the part of G-5 policymakers to take account of the circumstances prevailing in other G-5 countries in the formulation of their own domestic policies, and to engage in policy coordination.

Fourth, there was broad consensus among the G-5 on the role that exchange market intervention, especially coordinated intervention by the major countries, could play in guiding markets. In particular, the United States had moved away from its earlier laissez-faire attitude toward the value of its currency and come around to the view that exchange rate levels mattered. Further, all of the G-5 endorsed the conclusion reached in the Jurgensen Report¹--namely, that under appropriate circumstances, market intervention was a useful instrument of exchange rate policy.

Finally, I believe there was a sense of common purpose and responsibility among the Five, a sense that they were initiating a process that was important both for their own countries and for the world.

In these circumstances, G-5 solidarity continued--though not without some lively internal debates--for some time thereafter: through the Tokyo Summit in May 1986, where the G-7 agreed to use a set of objective indicators to assess economic performance and guide policy; and through the meeting at the Louvre in February 1987, where, after a substantial further decline of the dollar, the G-7 agreed that exchange rates were broadly in line with fundamentals and undertook to stabilize the three major currencies within particular "reference ranges."

In retrospect, more emphasis should have been placed--both at the Louvre and afterwards--on the macroeconomic discipline needed to underpin the objective of exchange rate stability. Nevertheless, it was impressive what the G-7 could achieve in the market, even after the Louvre exchange rate ranges had been abandoned. One episode that stands out in my memory occurred in April 1990. At that time, Japanese stock market prices were plummeting and the yen was declining dramatically, following the bursting of Japan's "asset-price bubble." Although Japan had raised official interest rates in several steps and the United States was reducing interest rates in the face of a weakening economy, these shifts in economic fundamentals were not yet reflected in the value of the yen. In these circumstances, mention of "the decline of the yen against other currencies and its undesirable consequences for the global adjustment process" in the G-7 statement issued in Paris appeared to awaken the market to these shifts, bringing a halt to the yen's decline. Thereafter, the additional nudge to the market contained in the G-7 statement released in Washington the following month helped launch a substantial recovery in the value of the yen.

What has befallen G-7 coordination in more recent years? I see several developments that have eroded policy coordination among the Seven and their confidence in coordinated exchange market intervention. First, there was a reorientation of policy objectives within the G-7. The sense of economic interdependence in which the Plaza Agreement came to fruition later gave way to domestic preoccupations: in the United States, recovery from the 1989-91 recession; in Japan, management of its financial crisis; in Germany, unification. And while such issues of domestic stabilization merit attention, G-7 policy cooperation, not to speak of more ambitious policy coordination, suffered as G-7 members, each pressed by their own domestic agenda, looked inward.

Second, the world economy has undergone a major change--globalization. And nowhere have the effects of globalization been more profoundly felt than in the increased size and agility of the international financial markets. Certainly, we know this from our experience in Mexico, as well as from data on international capital flows.² A further example can be found in the preliminary results of the most recent survey by major central banks of foreign exchange activity in major markets; these results suggest that over the last three years, average daily turnover may have increased by as much as 50 percent to well over $1 trillion.³ Certainly, trading volumes of this magnitude have not made the task of coordinated intervention any easier! On the contrary, developments such as these have contributed to a general skepticism--inside and outside the G-7--about the ability of monetary authorities to influence exchange rates in this way.

To these factors I would add a third major element in the decline of coordinated action among the G-7--one that I believe was decisive, but that has nevertheless gone largely unrecognized: the EMS crises of 1992 and 1993. These experiences--in which the pound and the lira left the ERM, the Spanish peseta was devalued, and ERM exchange rate bands were eventually widened considerably--illustrated all too clearly the danger of placing too much reliance on an exchange rate scheme and not enough on economic policy fundamentals. Furthermore, the crisis led the market to conclude that intervention no longer had any power to influence exchange rates--a view that, I believe, had a regrettable spillover effect on the G-7.

Fortunately, that gloomy chapter in the annals of international economic coordination is not the final one. Indeed, in 1995, the earlier--and I would say more successful--history of the G-7 has repeated itself in several key respects. Once again, a major misalignment emerged--this time an overvalued yen--that was clearly identifiable and in the obvious common interest of G-7 countries to correct. As indicated in the G-7 statement issued in Washington last April, a new consensus developed that exchange rate movements had "... gone beyond levels justified by underlying conditions in major countries..." and that "...orderly reversal of those movements...would contribute to...common objectives of sustained non-inflationary growth."⁴ Next, incoming economic data--notably, June data suggesting a resumption of growth in the U.S. after a sluggish second quarter, and evidence that the pace of recovery in Germany had slowed during the first half of the year--supported this view, as did moves by the Japanese authorities to ease short-term interest rates and liberalize rules for holding foreign currency assets, progress in U.S.-Japan trade negotiations, and the prospects for further fiscal consolidation in the U.S. In these circumstances, and with exchange rates having already begun to move toward more reasonable values, coordinated intervention by major central banks caught the market by surprise and reinforced the dollar's modest recovery.

So where do we stand now, ten years after the Plaza Agreement? Indeed, we are confronted with much the same dilemma that we faced then. We have seen the drawbacks inherent in placing too much emphasis on exchange rates at the expense of the underlying macroeconomic policies needed to achieve sustained, non-inflationary growth. We have also seen the risks of framing policies by focussing too narrowly on domestic conditions without giving proper weight to the signals conveyed by exchange rates. In spite of failures, the desirability of trying to stabilize exchange markets remains, and many, not least the G-7 Heads of State at their Naples Summit, but also the ASEAN Ministers and President Suharto, have recently urged the relevant countries and the IMF to redouble their efforts to achieve stability. What then can be done? I would offer the following suggestions.

First, I believe that the Seven need to reassert their international leadership. To do this, they will need to move beyond the modest requirements of policy cooperation as practiced in recent years and strive to fulfill the more rigorous requirements of policy coordination. At the same time, the G-7 must recognize that their renewed leadership will be for a different world--a world in which international trade and capital flows are greater than ever before and, thus, a world in which exchange rates and their misalignments have a much more profound effect on domestic growth and prosperity.

Second, I would urge the G-7 to build upon its achievement of last August. Although it is difficult to say exactly what the most appropriate set of exchange rates might be, it is clear that when the market drove the yen to about ¥80 to the dollar--beyond all reasonable relationship to economic fundamentals--the market got it wrong. Today, there do not appear to be any major misalignments among major currencies. That said, I would venture that the U.S. dollar continues to look a little weak against the deutsche mark and closely linked European currencies, as well as against the Japanese yen. Indeed, from a broader macroeconomic perspective, a slightly stronger U.S. dollar and a slightly weaker deutsche mark and yen might seem appropriate given that U.S. economy is operating near potential, that activity has been slipping in Germany and an overly strong DM may unduly impede German export growth, and that economic recovery is not yet fully under way in Japan. I would suggest, therefore, that the G-7 might reasonably aim toward inducing some further correction of the dollar against the DM and the yen, or at least resist a significant depreciation of the dollar from present levels.

For such an undertaking to be effective, however, it must be credible. Hence, the G-7 must also keep in mind the fundamental requirements for a stronger dollar and a more realistically valued yen over the medium and longer term--and work toward achieving these requirements. In this connection, I would urge the G-7 to seize the opportunity afforded by today's favorable macroeconomic outlook to strengthen economic fundamentals in their respective countries: in the United States and several other countries, by accelerating fiscal consolidation; in Japan, by continuing to open up the economy, by boldly reducing the still very high current account surplus through an increase in support for ODA and reform programs in developing countries, and, of course, by strengthening the financial sector and supporting domestic economic recovery; and in other countries, by accelerating structural reform, especially in labor markets. Of course, all countries must also aim toward a greater degree of domestic price stability; in addition to creating more favorable conditions for savings and growth, this would help promote more stable exchange rates over the medium term.

Provided that the Seven are willing to carry out such commitments, they should continue signaling their exchange rate views to the market, along with their readiness, if needed and in appropriate circumstances, to back up these views with coordinated intervention.

I believe that the actions I have just outlined would go a long way toward enhancing exchange rate stability. However, enhanced policy coordination among the G-7, while necessary, is no longer sufficient. As our experience with Mexico highlighted so clearly, the number of countries with a potentially global impact on the world economy has increased. It follows that relations between the G-7 and other major players in the world economy need to be strengthened accordingly. This brings me to my third suggestion, which concerns the role of the International Monetary Fund. I think that the IMF--with its virtually universal membership of 180 countries, its mandate "to promote exchange stability," and the unique expertise of its international staff--can contribute significantly to improving international policy coordination and, hence, the functioning of the international monetary system. In particular, by making more effective use of the IMF as an institution, the G-7 could make international monetary coordination more effective as well.

There are a number of specific ideas as to how this IMF "machinery" could be put to more effective use. Let me mention only a few that would be effective and practical. First and foremost, the Seven could draw more heavily upon the Fund's analysis of exchange rates and the macroeconomic policies that help determine them. The Fund is well-equipped to carry out such analysis. It has the technical resources to evaluate exchange rate and policy developments and to assess their implications for the international economy. In addition, the Fund's recent efforts to enhance the quality and timeliness of the data it receives from its member countries are improving the effectiveness of its "early warning system." Moreover, as a multilateral institution, the Fund is uniquely suited to take account of the needs of the international community, something which gives particular relevance to the efforts of the Chairman of our Interim Committee in convincing the members of that Committee to use it more and more as the only global forum we have for regular, frequent, frank, and timely discussions on macroeconomic policy and exchange rate matters.

In conclusion, I do not believe that the time is ripe for a leap beyond the "reference ranges" embodied in the Louvre Accord, which some, even today, would regard as premature. However, that does not mean that we should not strive toward the still worthy objectives that are within our grasp. Enhanced international monetary coordination and exchange rate stability are, in my view, two such objectives--and ones that the IMF stands ready to assist the G-7 and other countries in achieving.

---

1. "Report of the Working Group on Exchange Market Intervention" (March 1983) produced under the chairmanship of M. Philippe Jurgensen by the Working Group on Exchange Market Intervention, which was established at the Versailles Summit (June 4-6, 1982).

2. For example, as pointed out by Chairman Greenspan, whereas world trade in nominal dollars increased by about 125 percent between 1983 and 1993, the stock of cross-border assets held by banks grew by 250 percent over the same period, and annual issuance of international securities increased by 300 percent between 1984 and 1994. (Alan Greenspan, "Challenges for Central Banks: Global Finance and Changing Technology," Remarks at Annual Monetary Policy Forum, Stockholm, April 11, 1995.)

3. Financial Times, September 20, 1995, p. 1.

4. "Report of the Working Group on Exchange Market Intervention" (March 1983) produced under the chairmanship of M. Philippe Jurgensen by the Working Group on Exchange Market Intervention, which was established at the Versailles Summit (June 4-6, 1982).