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How Effective Will the IMF's New Surveillance Framework Be?

Amidst criticism of lack of effectiveness of its surveillance over the international monetary system, the International Monetary Fund adopted a new surveillance decision in June 2007, replacing a 30-year old earlier decision. As dialogue and persuasion remain the hallmark of effective surveillance, the credibility of the new decision hinges on its implementation in an even-handed manner between developed and developing countries and among countries that have floating exchange rates and managed exchange rates. Governance reform of the IMF with greater voice and participation of developing countries and emerging market economies becomes important in enhancing their shared commitment to effective implementation of the new decision.

akishore@imf.org dmohanty@imf.org

Against this background, the objectives of this paper are twofold. First, given the legal and technical nature of the Fund’s surveillance framework, this paper attempts to put in perspective the developments leading up to the adoption of the new decision.4 Second, the paper looks at some of the key issues that arise in the process of implementation of the new decision. In this direction the rest of the paper is organised as follows. Section 2 discusses the mandate of IMF surveillance. Section 3 gives the salient features of the new decision and compares it with the earlier decision. Section 4 discusses the possible implications for countries with a particular reference to India.

Salient Features

PERSPECTIVEMay 3, 2008 EPW Economic & Political Weekly34added in the new decision. We evaluate the features of each principle.3.4 ExchangeRateManipulationAs per Principle A, member shall avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of pay-ments adjustment or to gain an unfair com-petitive advantage over other members. This principle was difficult to opera-tionalise because of its general nature and the inherent ambiguities. The Fund could not come up with a technical explanation of what constitutes “manipulation of ex-change rates”.13 Manipulation would mean deliberate adoption of unfair means to achieve some objective. In such a scenario, the burden of proof rests with the Fund, if the Fund were to determine that a country is manipulating its exchange rate. The 2007 Decision makes a major change as it adds an explanatory Annex to Principle A to provide further guidance for operationalising this principle. It explains that “manipulation” could involve policies directed at affecting the level of exchange rate. Simultaneously, it recognises that manipulation could also occur by direct-ing policies that prevent a movement in the level of exchange rate. It is, however, important to recognise that policy induced movement, or a lack of movement, in exchange rate by themselves cannot be construed as “manipulation” as countries have the freedom of choice of their exchange rate regimes. For example, a country following a fixed exchange rate regime pegged to a currency or a basket of currencies may have to conduct its policies to maintain the peg. In order for such le-gitimate policy choices to be termed as “manipulation”, there would need to be a proof of a clear malafide intention.Even if the Fund were to determine that, a country is manipulating its exchange rate, it does not mean that the country inques-tion is in breach of its obligations to the Fund under the Articles of Agreement. In order for the country to be in breach of its obligation the Fund would have to addi-tionally prove that the country in question is manipulating its exchange rate to secure “unfair competitive advantage” over other members. How does the Fund determine “unfair competitive advantage”? The Fund would have to establish two factors. First, the memberisengaged in policies for the purpose of securingfundamentalex-change rate misalignment in the form of an undervalued exchange rate. Second, the purpose of securing such misalign-ment is to increase net exports.3.5 ExchangeRateMisalignmentThus the new decision introduces the concept of “fundamental exchange rate misalignment” to judge the appropriate levelof the exchange rate. The exchange ratecould be misaligned with the funda-mentals because of both structural and cyclical factors. The misalignment could manifest itself both in the form of over-valuation or undervaluation of exchange rate. What would matter to establish manipulationfor gaining an unfair com-petitive advantage, however,isundervalu-ation of the exchangerate. The magnitude of undervaluation and the policies leading up to such undervaluation would be im-portant. Given the current state of know-ledge on empirical estimation of exchange rate and the fact that different methods produce divergent estimates, it would indeed be a challenge to prove beyond reasonable doubt the exchangerateofthe member is fundamentallyundervalued. Since it is difficult to measure“equilibrium” flows of capital from one country to another, it is equally difficult to define meaning-fully “fundamental equilibrium” exchange rates [King 2006]. The Fund has developed three comple-mentary quantitative techniques – macro-economic balance approach, reduced-form equilibrium real exchange rate approach, and external sustainability approach – under its Consultative Group on Exchange Rate (CGER) issues for exchange rate as-sessment. The Fund supplements the results from this exercise with country specific information to arrive at informed judg-ments about medium-term real exchange rates and current account balances.14 As King (2006) has pointed out: because domestic demand is no longer constrained by current national output, a current ac-count deficit does not necessarily indicate any “fundamental disequilibrium”. On a discussion on exchange rate misalignment, The Economist (June 23, 2007) pointed out, “the awkward truth is that it is almost impossible to be sure when a currency is misaligned, let alone by how much”.3.6 A New PrinciplePrinciples B and C remain unchanged from the 1977 Decision which essentially recognise the need for a country to inter-vene in the foreign exchange market to counter short-term disruptive movement in its exchange rate. However, the new decision adds a new Principle D which enjoins upon the members to “avoid ex-change rate policies that result in external instability”. The new decision does not provide a direct definition of what is meant by “external instability” while it defines “external stability”, the obverse of which could mean that members should avoid exchange rate policies that induce a balance of payments position that could give rise to disruptive exchange rate movement.3.7 Treatment of Currency UnionsIt is important to underscore that external stability would be assessed at the level of each member except for the members in a currency union. In a currency union as exchange rate policy is determined at the union level, the concept of external stability would apply at the union level. This raises a piquant situation and an apparent asymmetry in surveillance between indi-vidual countries that are outside any cur-rency union and those that are within a currency union. There is a genuine apprehension that as the focus of the new surveillance decision is on exchange rate and external stability, the surveillance process may be less rigorousfor countries in the currency union. The new decision seeks to address this issue by clarifying that “the Fund’s assessment of policies of a member of the currency union will always include an evaluation of deve-lopment in the member’s balance of pay-ments”. The focus would be more on domestic policies and a member’s policies promoting its own domestic stability would be considered by the Fund to be promot-ing external stability at the union level. 3.8 Operational IndicatorsIn order to assess the observance of the four principles discussed above, the Fund would look at certain indicators such as a protracted large-scale intervention in one
PERSPECTIVEEconomic & Political Weekly EPW May 3, 200835direction in the exchange market, an un-sustainable level of external borrowings and large accumulation of foreign assets. Most of the indicators remain unchanged between the 1977 Decision and the new decision. The new indicators that have been added are: (1) fundamental exchange rate misalignment; (2) large and prolonged current account deficits or surpluses; and (3) large external sector vulnerabilities, including liquidity risks, arising from pri-vate capital flows.The most substantive addition to the list of indicators, in our view, is the funda-mental exchange rate misalignment. The determination of fundamental exchange rate misalignment in a conclusive manner indeed would be a challenging task as dis-cussed earlier. Nevertheless, the new deci-sion makes a progress insofar as it formal-ly recognises the concept of exchange rate misalignment as a tool for assessing the appropriate level of exchange rate.3.9 ModalitiesofSurveillanceIn terms of modalities of surveillance, there is a greater emphasis on cross-country spillovers as “the Fund’s advice will be informed by a multilateral framework that incorporates relevant aspects of global and regional economic environment”. While the new decision is concerned with bilateral surveillance, it is expected that there would be greater consistency with multilateral issues. In terms of the procedure of surveil-lance, the new decision does not make any significant change from the 1977 Decision. It basically underscores that fact that the Fund would hold annual consultations with member countries and such consul-tations would be brought to a conclusion by a discussion in the executive board.4 Implications for CountriesIn the course of review of the 1977 Decision as a run up to the formulation of the new decision, the IMF executive board had for-mulated three guiding principles: (1) no new obligations for the members should be introduced; (2) due regard should be paid to country circumstances and the need for even-handedness; and (3) flexibility should be maintained to allow the evolu-tion of surveillance. This was confirmed by theIMFC in its April 2007 meeting. Insofar as the new decision encompasses these principles, there should not be a signifi-cant difference in the practice of surveil-lance. However, by setting clear expecta-tions for the practice of surveillance, the new decision is expected to help improve the quality, even-handedness, and effec-tiveness of theIMF’s surveillance. It also “brings greater clarity and specificity to what exchange rate policies countries should follow and when these policies may be of concern to the international community”. With regard to surveillance over other macroeconomic policies – viz, monetary, fiscal and financial sector policies – there is greater clarity that such policies should be covered to the extent that they are rel-evant to the promotion of external stability. India’s PositionIndia’s response to the revision to the 1977 Decision has evolved over time. Given the structural asymmetries between devel-oped and developing countries, we were initially of the view that any revision, however desirable, would have greater implications on developing countries than developed countries. Moreover, the 1977 Decision has been flexible to allow surveil-lance to evolve with the changing global economy. This was reflected in India’s finance minister’sIMFC speech in Septem-ber 2006 that the rationale for the revision needs to be thought through carefully in the context of the MTS. However, as a more broad-based approach evolved by the February 2007 meeting of the board with the acceptance of three principles that should guide the revision. This was reflected in India’s acting governor’sIMFC speech of April 2007 showing support for efforts that would enhance the relevance of sur-veillance and increase its effectiveness. India, as a founding member of the Bretton Woods Institutions, remains com-mitted to reform of the Fund so that it re-mains relevant in the changing global context. The new decision broadly takes into account the particular concerns ex-pressed by developing and emerging market economies including India. As regards the implications of the new decision, it is expected that the focus would be more on external stability and exchange rate issues. As regards India, with a market determined exchange rate and trade and current account deficits, it is unlikely that there would be any significant change in the current practice and focus of surveillance.5 ConclusionsThe Fund surveillance has mainly been criticised on the ground that it lacks focus and in the process has lost its effective-ness. The important question that arises is whether the new surveillance decision would make the Fund surveillance more effective. While it is too early to assess the impact of implementation of the new deci-sion, it marks an improvement in several directions. Firstly, it attempts to improve the operational basis of surveillance by clarifying certain concepts and objectives without altering the basic mandate of surveillance as enshrined in ArticleIV. Secondly, it sharpens the focus on ex-change rate surveillance and formalises the notion of “fundamental exchange rate misalignment” for quantitative assessment of the level of real exchange rate, though the final exchange rate assessment wouldneed to be tempered with judgment.However, given lack of professional agreement on what constitutes a fundamental exchange rate misalignment, application of this concept would continue to be contentious. Thirdly, it clarifies the nature of surveillancefor members in currency unions. Finally, it attempts to strike a delicate balance on the level of surveillance on exchange rate policy and other macroeconomic policies with the latter coming in for closer scrutiny. It attempts to maintain the necessary safeguards for domestic policies to evolve towards domestic stability.Effectiveness of SurveillanceNow the question is: would the new decision make Fund surveillance more effective? The developments in the global economy since the adoption of the new decision point to just how challenging it is for surveil-lance to be effective. This is evident from the subprime crisis in the US which has spilled over to other advanced financial markets. In all fairness, the Fund had drawn attention to increasing financial risks in its flagship publications such as theWorld Economic Outlook (WEO) and the Global Financial Stability Report (GFSR). But, had the Fund been more persuasive in its policy advice to the concerned countries, it might have triggered timely corrective

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