Rewriting the rules on exchange rates

Is monetary system reform on the cards?

16 April 2010

The financial crisis has prompted renewed interest in reform of the international monetary system (see Update 68), with the role of the IMF squarely up for debate. As countries are starting to take sides for or against a comprehensive overhaul, regional initiatives may offer greater hope of change.

London-based think tank Chatham House published the latest raft of proposals in March in a multi-authored report, Beyond the dollar: Rethinking the international monetary system. It examined the history of reserve currency development, IMF surveillance on exchange rate policies and the role of the international reserve asset housed at the IMF – the special drawing right (SDR, see Update 65).

The report’s most eye-catching recommendation, from a chapter authored by former member of the Bank of England’s monetary policy committee DeAnne Julius, was for the establishment of “a new committee (the ‘International Monetary Policy Committee’) to produce regular recommendations to the IMF board for new SDR allocations.” It would be modelled on the governing boards of central banks, and would include the heads of the central banks of currencies that make up the SDR (currently the US dollar, UK pound, Japanese yen and euro) as well as “four other term-limited individuals chosen on the basis of their economic expertise.”

leave currencies to the vagaries of the market

Professors Gregory Chin and Wang Yong’s contribution concludes that in China the consensus on the monetary system is that “a fundamental shift is not only needed but also now imminent.” While the Chinese commentators that Chin and Yong review do not agree on a single solution, “Beijing does not appear to favour institutional alternatives to a global monetary system that is anchored in the IMF and the Bank for International Settlements.” This echoes the call from the Chinese central bank in 2009 for the SDR to be at the centre of reform (see Update 67, 66).

Jim O’Neill, head of global economics for investment bank Goldman Sachs, who has publically questioned the continued assumption that the Chinese yuan is undervalued against the US dollar, writes in his chapter of two possible extreme scenarios. Either the yuan ends up as one of three freely floating currencies that serve as the lynchpins of a multicurrency reserve system, or the SDR becomes the global reserve currency in a system characterised by restricted capital flows and closely controlled currency valuations against the SDR.

Overall the report editors opt for the former of O’Neill’s scenarios, recommending in the executive summary “a multicurrency reserve system for a multipolar world economy.” The UN Conference on Trade and Development (UNCTAD) prefers the latter solution. In a March policy brief titled Global monetary chaos, UNCTAD calls for a multilateral response rather than “to leave currencies to the vagaries of the market” and allow currency speculation. It proposes a “constant real exchange rate rule”, implying globally fixed exchange rates.

Despite the debate, some countries are still counting on the dollar. In February, Muhammed Al-Jasser, governor of the Saudi Arabian Monetary Agency, said the dollar remained pre-eminent and called for a “natural evolution of reserve currencies for a multi-polar reserve system rather than an imposed solution.” Likewise, Reserve Bank of India governor Duvvuri Subbarao said that he “cannot see the $380 billion of SDRs becoming a reserve currency for global trade.”

Changing exchange rate ideas

A recent IMF review of exchange rate systems marks another blow to IMF orthodoxy (see Update 70). The study was carried out to “review the stability of the overall system of exchange rates” and will be published as an occasional paper, meaning it has not received board or management endorsement. Using a “more nuanced” methodology, it concludes “in contrast to the earlier studies … that a thorough analysis of the cross-country data does not support any single ‘prescription.’”

In particular it seeks to distance the IMF from its former insistence on either fully floating exchange rates or commitment to a hard currency peg, known as corner solutions (see Update 66). The paper instead finds that ‘intermediate regimes’– currencies that are pegged to baskets or within bands, or floated but with significant government intervention – offer advantages of higher economic growth because they “represent a happy balance between pegs and free floats.” This turns decades of IMF advice on its head. If incorporated into official IMF policy, countries would have more policy space to decide which exchange rate regime best suits their circumstances.

On the other hand, some thinkers argue that the IMF has not been tough enough on developing countries. The US Treasury’s annual report on currency manipulation, originally due in mid-April but now postponed, may spark a bilateral trade row with China over exchange rates. The IMF has continued its public pronouncements that the Chinese currency is undervalued. The Chinese wire service Xinhua interviewed the IMF’s chief economist Olivier Blanchard in mid-February, and while he concurred that the yuan is undervalued, he called even a 20 per cent revaluation no “panacea for the United States nor for the rest of the world.” Xinhua said Hans Timmer, director of the World Bank’s development prospects group, agreed with that assessment in late March, adding: “I don’t think you can make the case that the yuan is undervalued if you have an economy which has had no significant domestic inflation for five or ten years,” he said.

Arvind Subramaniam, a former Fund official and now senior fellow at Washington think tank the Peterson Institute, argued that currency and exchange rate disputes should not be handled at the IMF, but instead at the World Trade Organisation (WTO). Subramaniam acknowledges “the IMF suffers from problems of eroding legitimacy and inadequate leverage. Emerging market countries still complain that its antiquated governance structure does not reflect economic realities. Moreover, the IMF has rarely, if ever, effectively influenced the policies of large creditor countries even where such policies have had significant negative effects on others. The IMF and its managing director have become more vocal in characterising the renminbi as ‘substantially undervalued’, but this has been water off the Beijing duck’s back. The IMF is, sad to say, toothless.”

Subramaniam said “undervalued exchange rates are de facto protectionist trade policies” so that “what is needed is a new rule in the [World Trade Organisation] proscribing undervalued exchange rates.” The proposal, targeted specifically at China, would have “the IMF continuing to play a technical role in assessing when a country’s exchange rate was undervalued, and the WTO assuming the enforcement role.” He is essentially admitting that the IMF is not up to the job of overseeing the exchange rate system.

Regional monetary arrangements abound

Amid the diverse thinking about the monetary system and how to manage exchange rates, regional initiatives are going ahead. Most notably the fears of a Greek debt crisis prompted Daniel Gros, of Brussels-based think-tank Centre for European Policy Studies, and Thomas Mayer, of German private bank Deutsche Bank Group, to propose a European Monetary Fund (EMF) in early February. Amid European opposition to eurozone countries going to the IMF, the proposed EMF was to be discussed at a European Union summit scheduled for mid-April.

Before the ASEAN+3 summit of East and Southeast Asian countries in early April, the Chiang Mai Initiative Multilateralisation entered into force. This is a regional financing arrangement created to “provide financial support to countries with short-term liquidity needs and to supplement existing international financing arrangements” (see Update 67, 66). In Latin America, some trade between the ALBA grouping of eight countries began to be invoiced in their newly created unit of account, the unified regional compensation system (SUCRE), in early February. The SUCRE is intended to be one pillar of a regional economic system that plays down the importance of the US dollar, the IFIs and rich countries.

The main point of difference between the regional approaches is the role of the IMF. In the end, eurozone countries begrudgingly agreed to the German demand that any lending to Greece would have to be done in concert with the IMF, but the proponents of the EMF have not suggested a formal link to the IMF. However, IMF involvement is explicitly required for certain levels of lending under the Chiang Mai arrangement, while ALBA explicitly rules out any linkage to the IMF.

The IMF mandate review (see Update 70) will look at the options for cooperation between the Fund and regional arrangements, as well as the reform of the international monetary system. Given the lack of global consensus on financial and monetary reforms, change to any of these systems is likely to be slow indeed, unless a further crisis galvanises political will.

BOX: Controversy over IMF’s likely dismissal of financial transaction taxes

Newspaper reports have indicated that the IMF will argue that a financial transaction tax (FTT) would be too difficult to implement, and instead will recommend a levy on banks based on either their liabilities or cash flow.

The IMF will deliver its study on ways that the banks can pay for the crisis (see Update 68) to the G20 finance ministers in mid-April, just before the World Bank and IMF spring meetings. The study is expected to argue that an FTT, dubbed a Robin Hood tax by campaigners across the world, would be too easy to evade and that some derivatives contracts are too complex to be taxed in such a way.

In contrast, researchers Rodney Schmidt, Stephan Schulmeister and Bruno Jetin, all experts in transaction taxes, note “it is technically easy to collect a financial tax from exchanges … transactions taxes can be collected by the central counterparty at the point of the trade, or automatically in the clearing or settlement process.” A February paper from the Trade Union Advisory Committee argues that “an FTT, unlike the insurance proposal, would provide governments with a powerful regulatory tool” and “is thus the most appropriate ‘low-cost’ instrument for tackling volatility in asset prices and for downsizing the global banking industry.”