The Hindu Business Line : The IMF’s new mandate

A panel recently found that “the rules of the game for exchange rate surveillance are unclear, both for the IMF and member-countries.” But without correcting the deficiencies and building surveillance capabilities within the Fund, the IMF was in a hurry to set up a new framework. What is needed is a compromise, taking into account the changed global economic balance, says K. SUBRAMANIAN.

The annual meetings of the World Bank/IMF are scheduled for three days from October 20, 2007. The meetings take place under the shadow of a major financial crisis in the US and seething differences within G-7 over the dollar value. The Potomac may not exactly be set on fire.

One of the items coming under the rubric of “IMF Reforms” is the new framework for surveillance. On June 18, the Managing Director, Mr Rodrigo de Rato, announced the revised framework and he sounded victorious.

The US Treasury was quick to share his joy. The US Treasury Secretary, Mr Hank Paulson, said: “The revised decision sends a strong message that the IMF will put exchange rate surveillance back at the core of its duties.”

Sadly, neither the IMF nor the Treasury realised that what they have achieved after two years of work is messy and would not advance their interests. What is the story?

The new mandate

By the 1970s, the Bretton Woods regime of exchange rate arrangements, otherwise known as par values, collapsed and the global economy moved to a system of flexible exchange rate arrangements.

After prolonged and heated negotiations, the Articles of Agreement of the IMF were formally amended, giving members the freedom to adopt exchange rates of their choice. Under the new dispensation, the exchange rate became a variable clearly within the domain of their economic policies, either to be used as policy instruments or to be the result of policies, or both. Correspondingly, the role of the IMF was changed from that of an umpire to an observer.

The mandate comprised three principles — the freedom to adjust exchange rates when it was needed in response to underlying conditions; the freedom to pursue member’s domestic policies and exchange rate necessary for financial stability, and, last, it enjoined on members to pursue responsible exchange rate policies and avoid policies to interfere with the adjustment process or gain undue advantage over others.

The new framework approved by the Executive Board on June 15 has become the focus of debates and many controversies. It leans on the 1977 mandate, adding a fourth principle: A member should avoid exchange rate policies that result in external instability.

The earlier approach that countries shall “avoid manipulating exchange rates” is replaced by a new one which characterises member’s actions as “securing fundamental exchange rate misalignment in the form of an undervalued exchange rate” in order “to increase net exports.”

Collaborative process

The new outline emphasises that surveillance is a collaborative process based on dialogue and persuasion; that there should be candour in the IMF’s assessment and pronouncements; it has to be even-handed and should pay due regard to country circumstances and there should be no additional obligations. These were included to safeguard the concerns expressed by members of the G-24.

In retrospect, it may be argued that the idea of revising the 1977 framework is flawed and based on an incomplete understanding of the background to the compromise made in 1977.

As Edwin Truman of Peterson Institute, Washington D.C., explains: “The problem the Fund and its members face today is that those words were a 1975 compromise between the US and French positions on the exchange rate regime. This framework and the associated principles for the surveillance of exchange rate policies adopted in 1977 were never fully embraced by the membership of the Fund.”

Prof James Boughton, the IMF historian, observes: “It is clear from the record of deliberations on the Second Amendment in the mid-1970s that the Fund’s governors did not agree on the precise meaning of “firm surveillance” and even that phrase was introduced as a substitute for agreement on a more precise reform of the exchange rate system.” As he goes on to elaborate, “both sides recognised that the principles and procedures of surveillance would have to be worked out gradually through experience.”

Sadly, it was not done. For 30 years, the issue was in a limbo and the IMF had no role in surveillance. It suited the developed countries to live with any exchange rate system as long as their dominance was not jeopardised. Indeed, there were occasional skirmishes with Japan or Korea and these were patched up within the G-7.

Weak framework

The legal framework behind the 1977 decision was infirm. An IMF document prepared by its Legal Department (Article IV of the Fund’s Articles of Agreement: An overview of the Legal Framework, Legal Department, June 28, 2006) explains how provisions regarding domestic policies were ‘soft’ in recognition of the fact that members would not give up sovereignty over domestic policies even if they had international impact.

More significantly, the note explains: “ …. The substance of Article IV was effectively negotiated by a small group of members outside the Executive Board and presented a delicate political compromise.”

When the text was presented to the Board by the group, “it was generally understood the scope for substantive change was limited, notwithstanding the fact that a number of Executive Directors — and staff — expressed concern regarding the vagueness and ambiguity of a number of its terms.”

The note confessed: “As a result, there is very little legislative history to illuminate the meaning of provisions.” It is on to this weak framework that a new principle is added with the hope that the IMF would march into an era of global surveillance.

Review of 1977 decision

As explained earlier, there was benign neglect for 30 years and the IMF’s difficulties in recapturing the role were described in a background paper (IMF: Review of 1977 Decision over Exchange Rate Policies: Background, June 30, 2006) thus: “It remains the official bedrock and foremost display window of the Fund’s mandate, yet surveillance practitioners, both on the side of the Fund staff and on the side of the country authorities, are unacquainted with it – a fate that, in some respects, has been shared by Article IV itself.”

The nature and manner of the1977 mandate took a heavy toll on the IMF. This was brought out in the Report of the Independent Evaluation Office (IMF Exchange Rate Policy Advice: 1999-2005 — An IEO Evaluation; May 17, 2007).

The IEO found that “the rules of the game for exchange rate surveillance are unclear, both for the IMF and member countries.”

This was due to “the complex nature of the 1977 decision and the failure subsequently to translate and adapt that understanding into specific guidance on key points.”

It found an “effectiveness gap” in the IMF’s main line of business. It drew attention to other shortcomings and added that unless they were addressed, “there could be serious implications for the ability of the IMF to discharge its responsibilities in the future.”

It noticed what is called “a silos approach” where various divisions do not act in consonance. Surprisingly, without taking steps to correct the deficiencies and build surveillance capabilities within the Fund, the IMF was in a hurry to bring about a new framework. What was needed was a new compromise taking into account the changed global economic balance, as was done in 1977, and not tinkering with the 1977 decision.

China and the IMF

China has warned the IMF not to back the US pressure for faster appreciation of the renminbi. It has requested it to carry out it duties on mutual understanding and respect.

With all the advancements in economics, there is no agreement on how exchange rates come about and which is the equilibrium or best rate suited to a country. Countries will not give up their sovereign right over economic policies.

Even as the US was trying to set the IMF on China, it had a taste of its own medicine. The IMF came out with a finding in its August 1 report that the US dollar was “over valued.”

The US Treasury objected to the finding and Mr Paulson told Congress that it’s impossible to measure a currency’s fair value. As reported by Bloomberg (August 23), the US Treasury took two years to persuade the IMF to police global currency markets and just two months to trash the initiative once the IMF adopted it.

The IMF lacks the power to impose its views on members. It is neither a policeman nor a judge. The only punishment is that the member would lose the benefit of drawing on its resources.

Unfortunately, the new framework seems to involve the IMF in the US-China currency spat. As a Financial Times report (June 24) said: “Officials fear that if China is put in the dock it will ignore the fund and develop an Asian monetary arrangement to supplant it.” Mr Rato’s victory would be pyrrhic.

(The author is a former Finance Ministry official with extensive experience in international trade and financial issues.)

More Stories on : RBI & Other Central Banks | Mortgage | Forex

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
The underbelly shows

Dividend versus deemed dividend

The travails of commission agents

Why cricket match is like a celebrity marriage

Liquidation proceeds — No priority for tax dues

The ‘Force of Attraction’ rule

Don’t quit, just stay put!

The IMF’s new mandate

I-T ombudsman

Occupational health