IFI governance


Heated exchanges over exchange rates

IMF decides on surveillance reform

2 July 2007

versión en español

The IMF executive board agreed to revise the legal framework for bilateral surveillance in June with the final text incorporating many of the safeguards demanded by developing countries but still angering the Chinese.

Since last year the IMF has been mulling a change to the 1977 Decision on surveillance over exchange rate policies, the document that details member state obligations and the way the IMF will monitor them (see Update 53). Much of the focus of developing countries has been on ensuring that surveillance is more even-handed, a code word for preventing the IMF staff from targeting developing countries with harsher analysis and recommendations.

the IMF was simply not as effective as it needs to be

The surveillance decision is important because it sets out how the IMF will interact with each of its members and what analyses it will make of a member’s economy. For those without a lending programme from the IMF, which includes almost every middle-income country except for Turkey, surveillance is the chief implement the IMF uses to advise or criticise member states.

The June decision to finally revise the surveillance framework adds one new principle to guide IMF member state exchange rate policy: “A member should avoid exchange rate policies that result in external instability”. This complements the existing three principles: to avoid manipulating exchange rates for competitive advantage; to intervene in exchange markets to counter disorderly conditions; and to take the interest of other members into account when intervening in the market.

Agreeing on the definition of “external stability” was one of the most difficult parts of the discussion. In the end the directors agreed that: “’External stability’ refers to a balance of payments position that does not, and is not likely to, give rise to disruptive exchange rate movements.” Thus a persistent balance of payments deficit or surplus which does not lead to wild fluctuations in exchange rates will not automatically fall foul of the principle. Earlier drafts of the text had included “fundamental exchange rate misalignment” as an indication of external instability, but this proved unacceptable to China and other developing countries.

As part of the compromise, the clause on misalignment was kept in a later section of the decision that describes the situations that “would require thorough review and might indicate the need for discussion with a member”.  More thorough analysis would also be triggered by “large and prolonged current account deficits or surpluses”.

The language on fundamental misalignment had been vigorously opposed by some emerging markets, particularly China, as being a green light for the Fund to target developing countries with pegged exchange rates. Many countries complain and the IMF board recognised in its discussion that measuring misalignment is a very uncertain task. The Chinese executive director was the most vocal opponent of the final text, with Iran and Egypt also expressing reservations. After the decision the Chinese central bank publicly rejected the new surveillance framework and called on the Fund to “strengthen policy surveillance over those members who issue major reserve currencies and exert thus vital impact on the stability of global system”.

Limiting the scope of surveillance

Another safeguard demanded by the G24 group of developing countries surrounded the burden of proof for alleged violations of the principles. They won the concession that “members are presumed to be implementing policies that are consistent with the principles” and that members would receive “the benefit of any reasonable doubt, including with respect to an assessment of fundamental exchange rate misalignment.”

The decision, which only applies to bilateral surveillance and not lending arrangements or multilateral surveillance, also indicated that “the Fund will focus on those policies of members that can significantly influence present or prospective external stability.” This clause will reduce the IMF’s analytical work on microeconomic factors and economic policies which are not directly related to a risk of disruptive exchange rate movements, such as public pension reform. This is a crucial limit on the Fund’s reach. If this principle were to be extended to IMF lending arrangements it would do away with many of the conditions the Fund currently places on borrowers.

The decision also explicitly indicates that the Fund will not require a change in member state domestic policies as long as the member state is “endeavour[ing] to direct their domestic economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to their circumstance”.

It is also unclear how this decision will impact the actual practice of bilateral surveillance, which is carried out for most members through the annual Article IV report that the IMF produces on member countries’ economic health, because the operational guidance note has yet to be produced by management for the staff. Operational guidance notes are not publicly available. On the modalities of the surveillance the Fund now committed that advice “will pay due regard to the member’s implementation capacity”, “take into account the member’s other objectives”, and “take into consideration the disruptive impact that excessively rapid adjustment would have on the member’s economy.”

The revision was initially opposed by developing countries, including by the G24 in their communiqué at the spring meetings of the IMF. According to the communiqué the G24 ministers “remain doubtful that the revision … is necessary to pursue the objective of more focused and effective surveillance.”

To secure the agreement of the dissenting developing countries, who worried that IMF pronouncements on exchange rates might create instability or speculation in currency markets which could be detrimental to developing country interests, developed countries compromised on how the decision would be implemented. The decision explicitly accepted the demands from the G24 communiqué that no new obligations should be created, country circumstances should be considered, and flexibility should be maintained.

Officials from both developed and developing countries, who wished to remain anonymous, seemed agreed that the resulting consensus was a good decision even if it did not completely fulfil the objectives of everyone around the table. The UK Treasury said “This is a significant reform, which shows that the Fund is serious about modernising in response to a changing global economy”, but it did argue that further work needed to be done in the area of multilateral surveillance.

IEO report stirs the waters

The Independent Evaluation Office (IEO) report on exchange rate surveillance was completed early to feed into the discussions on revising the surveillance framework. Released in May, it found that in the evaluation period from 1999 to 2005 “the IMF was simply not as effective as it needs to be in both its analysis and advice, and in its dialogue with member countries.”

The evaluation cited numerous and complex reasons including failures by staff, management, the executive board and member countries. One of the clear subtexts of the report and subsequent discussions was the accusation that surveillance was not even-handed simply because the IMF has no ability to influence the exchange rate policy decisions of advanced economies. The evaluation finds: “The reduced traction is in danger of being extended to large emerging market economies, and beyond. Such an evolution is corrosive, breeds cynicism amongst the staff as well as the members, and builds on perceptions of a lack of even-handedness.”

The IEO’s top line recommendation was for a clarification of the rules of the game for the IMF and its member countries, supporting the idea of reviewing the 1977 decision, and for the development of practical policy guidance on key areas of potentially controversial exchange rate policy, such as the use and limits of currency market intervention. In the IEO’s view, IMF management also needs to give greater attention to ensuring effective dialogue with country authorities, including senior management getting involved in communicating with top-level country officials and IMF staff performance appraisals rewarding those who were successful in creating effective dialogue.

Another issue highlighted in the report was that in some cases country authorities refused to provide the data necessary for making appropriate analysis of exchange rate issues. “In not pursuing data issues more forcefully, including those related to intervention, staff gave high weight to maintaining smooth relations with the authorities and/or perceived a lack of support by management and the Executive Board for a stronger stance.” The IEO recommended a fuller analysis of the reasons behind the incomplete data provision.

IMF staff took affront at the allegation that exchange rate surveillance was ineffective, writing an 18 page response to evaluation highlighting the progress made since 1999 and the ongoing work agenda on surveillance improvement. They wrote: “All in all, the report’s consistently negative tone crowds out much valuable information and some useful conclusions.” The managing director likewise felt that the report “does not offer a balanced perspective in identifying remaining weaknesses and their relative importance.”

Despite the staff reservation about the IEO report, the board found much to agree with, endorsing the conclusion that the Fund was not as effective as it needed to be. They agreed that the Fund needed to “address any perception of asymmetry in its exchange rate surveillance.”  Despite most directors finding that the rules of the game remain unclear, there was no consensus on whether or how to develop clear practical policy guidance.

The directors also found fault with the dialogue between the staff and country authorities and agreed that “there remains scope to explore further ways to improve the dialogue with member countries, and to address any perception of lack of even-handedness. … Directors encouraged management to give consideration to the IEO recommendations in this area.”

The IEO is currently finalising its evaluation of structural conditionality in IMF programmes, which promises to be contentious. Following on to the recent debates on IMF governance, the IEO has issued a draft issues paper for an evaluation of IMF corporate governance. It will tackle issues of accountability and oversight between the board of governors, the executive board, the IMFC and the Fund’s management.