Good news

The IMF seems to be having a bit of a row over how to do exchange rate surveillance.

Why is that good news?

Because it suggests that the IMF actually is trying to do exchange rate surveillance.

That is something of a change. A good one, too.

For too long, the IMF generally took the view that all exchange rate regimes, and all exchange rates, were above average. Or at least above criticism from the IMF.

Any exchange rate regime, or any exchange rate, could be made to work with appropriate supporting policies.

If Argentina wanted to peg -- back in the 1998 to 2001 period -- to an appreciating dollar even as commodity prices fell and Brazil allowed the real to depreciate, no problem. Tight fiscal policy could produce the real depreciation needed to bring Argentina’s real exchange rate back into balance, or at least restore investor confidence in Argentine bonds, allowing Argentina to finance the deficits associated with its appreciated real exchange rate. If Saudi Arabia wants to peg to a depreciating dollar and have low rates of inflation, it can -- so long as it tightens fiscal policy. No matter that fiscal tightening would push up Saudi Arabia’s surplus, and thus impede global adjustment. And no matter that fiscal tightening would have significant implications for the distribution of the gains from higher oil prices internally, as it cuts off a key channel for broadly sharing the oil windfall. Those with fixed riyal salaries have seen their real external, and in some cases domestic, purchasing power fall.* But raising salaries with a deeply depreciated exchange rate would be inflationary.

So long as the IMF focused on the policies -- usually fiscal tightening -- the IMF thought necessary to make a country’s chosen exchange rate work, it could avoid getting into a fight over whether a country’s chosen regime was appropriate for its circumstances or, perhaps more importantly, an impediment to global adjustment. That left the IMF in its comfort zone (making recommendations about fiscal policy). But it also meant that the IMF more or less stood on the sidelines as a set of countries pegged to a depreciating dollar despite large and often growing external surpluses.

The IMF is now looking more closely at exchange rates. That makes some uncomfortable. And -- as is often the case -- matters of great importance get reduced to matters of process. In this case, the IMF’s process for doing exchange rate surveillance.

After spending a bit of time trying to read between the lines of the IMF’s latest report on exchange rate surveillance, I would bet that there is disagreement on at least four points.

-- What constitutes a "stable system of exchange rates." Some argue that stability means, more or less, not moving too quickly away from any existing exchange rate arrangement -- and, in practice, not allowing too much appreciation relative to the dollar. Others, including the IMF staff, argue that a stable system of exchange rates needs to avoid large disequilibria in the balance of payments that might lead,in the future, to large and disruptive moves. Consequently, in some cases avoiding sharp moves against a particular currency (say the dollar) can be destabilizing.

-- Is the dollar’s decline temporary, and should countries that peg to the dollar make permanent changes to their chosen exchange rate regimes in response to what be temporary moves in floating exchange rates? Some think that, in a sense, the problem isn’t dollar pegs but the dollar, and specifically dollar weakness. But the dollar should recover, as its weakness is temporary -- so there is no need for those who have pegged to the dollar to adjust. Others argue that there are fundamental reasons why the dollar needs to decline (that large US deficit) and that linking the currencies of the big surplus countries to the currency of a big debtor country creates the condition for a major disequilibria in the global balance of payments. Deficit countries need to depreciate against surplus countries, and that is hard so long as surplus countries peg to the currency of a big debtor.

-- How much weight should the IMF give to promises to adjust policies in the future? Some think that the IMF should focus not just on current policies, but on countries’ stated policy goals. Others argue that current policy offers a better guide to future policy that stated goals. I tend to agree. A large Asian economy, for example, first stated that it wanted more to shift the basis of its growth away from exports and investment in 2004. It then adopted policies -- notably a very restrained initial revaluation and an nearly equally restrained pace of appreciation against the dollar, together with controls on credit and tight fiscal policy -- that increased the contribution of net exports to growth.

-- What should the IMF do if a country’s chosen exchange rate regime, or market moves in a floating currency, inhibits effective global balance of payments adjustment? The IMF has a procedure for "special consultations" -- but this procedure has rarely been used in the past and its use now might send too strong a signal. The IMF seems to want to create a process for something more than an Article IV (i.e. standard) review and a formal special consultation over a country’s exchange rate regime.

It is no secret that anything that puts greater focus on exchange rates makes China nervous. Good. A review of the external spillovers of China’s exchange rate regime should make China nervous; China has for too long opted to subsidize jobs in the export sector (through its exchange rate regime) at the expense of jobs supplying the domestic market. That needs to change.

It limits the policy options of other countries -- notably countries that compete with China and don’t want to see their exchange rates appreciate relative to the RMB. Ragu Rajan thinks s a coordinated appreciation of Asian currencies might be needed, as no one wants to appreciate too much on their own; I tend to agree. It also inhibits global adjustment, as large surpluses necessarily imply large deficits elsewhere. China’s exchange rate regime -- together with the macroeconomic policies China has adopted to support its exchange rate regime -- has meant that its real exchange rate has hardly appreciated even as its current account surplus soared. That is a problem. China’s real exchange rate shouldn’t be close to its 2000 level when China exports about five times as much as it did in 2000.

If the IMF is going to be relevant to today’s world, it cannot ignore a country’s choice of exchange rate regime -- or the exchange rate its central bank targets. The debate that broke out recently is evidence that the IMF is willing to take risks to regain its relevance. To me, that is a good thing.

* The IMF hasn’t completely abandoned its old habits. The latest Article IV review for Saudi Arabia calls for fiscal tightening even as oil revenues soar: "In view of the limitations imposed on interest rate policy by the currency peg, fiscal restraint will be critical. Directors observed that strengthening prudential measures to contain credit growth will also help to reduce demand pressures." That is effectively advising the Saudis to adopt the same policies that led to China’s external surplus. And it seems that the majority of the IMF’s board believes that Saudi Arabia’s dollar peg has contributed to macroeconomic stability ("Directors observed that the peg of the riyal to the U.S. dollar has provided a credible anchor that has contributed to macroeconomic stability"). Hmmm. Does the IMF really believe that 10% inflation and wildly negative real interest rates are consistent with macroeconomic stability?

It is possible to argue that the world had an interest in the maintenance of the Saudi peg when the dollar was under pressure, as a Saudi policy shift might have triggered a dollar rout. But it is hard to argue that the peg has contributed to domestic macroeconomic stability in Saudi Arabia recently. Oil and the dollar have tended to move in opposite directions, and the Saudis need them to move together. A country with a large positive shock to its terms of trade generally should experience a real appreciation. The dollar peg implies that the only way this can occur is through a surge in inflation.