February 2, 2006
JS-4002

Remarks by
Under Secretary for International Affairs Tim Adams
At AEI Seminar
Working with the IMF to Strengthen Exchange Rate
Surveillance

Let me thank Desmond Lachman and the American Enterprise Institute for inviting me to speak to this seminar on the IMF's role in foreign exchange surveillance.

First, though, I want to discuss the overarching questions facing the Fund. The IMF is the world's central institution for global monetary cooperation. A strong IMF serves the interests of the United States and the world economy. Over the past decades, the Fund has done remarkably well, tackling the debt crises of the 1980s, helping transform the former Soviet Union and Central Europe, and addressing the emerging market crises of the 1990s. The IMF is indispensable.

But in a rapidly evolving global economic and financial system, the Fund faces the continuous challenge of re-tooling itself. Already, this decade, many new and fundamental questions have emerged regarding the IMF's future and relevance. Will the global community resolve imbalances in an orderly manner? With large emerging market countries across the world putting in place sound macroeconomic policy frameworks, adopting pro-growth policies, relying on private finance, and accumulating large stocks of foreign exchange reserves, will the Fund be needed as a major balance of payments lender? Crises will always happen, but can the Fund do better on ex ante crisis prevention? When crises erupt, how can they be best managed, especially when the dynamics of global capital flows are not fully appreciated? IMF transparency has been substantially enhanced, but is there more to be done?

The Fund's major shareholders and Management are tackling these issues and many others through the Managing Director's Strategic Review. The Managing Director will soon bring forward his ideas on how to strengthen the Fund's surveillance activities including exchange rate surveillance and broader integration of financial markets issues into surveillance. We welcome this exercise and we look forward to working with him constructively to achieve concrete results.

Today, I would like to offer my own thoughts on the very high priority issue of the IMF's role in foreign exchange surveillance. My objective is to table ideas for reforming IMF foreign exchange surveillance procedures to make surveillance more effective, to contribute to the debate which the Managing Director's Strategic Review is stimulating, and to help galvanize action by the Fund's shareholders – who set the tone and direction for the IMF – to better allow Rodrigo de Rato and the IMF's excellent staff to play their role as the world's preeminent monetary institution.

The Role of Exchange Rates

The IMF – its management, staff, and shareholders – has long struggled to strike the right balance in providing advice on the role of exchange rates. I recognize that this is not an easy issue to resolve as there are so many complicating factors. For example:

• The interaction between the exchange rate and domestic policies can run both ways. In a fixed exchange rate regime, the exchange rate is the central target of monetary policy. In a flexible exchange rate regime, the exchange rate is an outcome from other policies.
• Exchange rate changes can be influenced as much by developments abroad as at home.
• Countries' exchange rate regime preferences differ depending on whether an economy is relatively closed or open to tradable goods and financial flows, the extent of pass-through from exchange rate changes to domestic inflation, the flexibility of labor and other factor markets, the concentration of its trade, or the sophistication, credibility, and quality of a country's institutions.
• Imbalances themselves can be adjusted through domestic policy measures, exchange rate adjustment, or some combination thereof.

And, of course, we struggle with who should bear the burden of adjustment and by how much.

The international monetary system has also generally been characterized by an asymmetric bias, where pressures are more acute on deficit than surplus countries to bear the burden of global adjustment.

John Maynard Keynes, in particular, devoted himself to the issue of asymmetric bias when he worked on the initial plans for something that would eventually be known as the International Monetary Fund. Keynes worried about the potentially damaging effects of global current account imbalances and the fact that market forces were not very strong in compelling surplus countries to adjust. He believed that the IMF should have the ability to pressure surplus countries to play their part in resolving imbalances and developed what was then known as the "scarce currency clause." That clause faded into history as an unused relic of the Bretton Woods system of fixed exchange rate regimes, but the need for a lever on surplus countries remained. The asymmetric bias of the international monetary system was evident in the late 1960s ahead of the demise of the Bretton Woods system. It is also present today in discussion of the need for more flexible exchange rate regimes – including in emerging Asia.

Today's global imbalances are not so dissimilar from the past in the sense that they require a shared, multilateral solution to achieve an orderly resolution. Let me be clear, the United States has its part to play in this process by raising national saving, and in particular continuing on the path of deficit reduction. The Administration does not and will never shy away from this point.

But the solution also requires an IMF capable of demonstrating strong leadership on multilateral exchange rate surveillance. The IMF membership should endorse such an enhanced role for the IMF, restoring its central role on exchange rates. There are four areas where our experience clearly points to the need for concrete improvements: clarifying exchange rate surveillance principles; Article IV reviews; the special consultation mechanism; and multilateral surveillance reforms.

Clarifying Principles of IMF Surveillance over Exchange Rate Policies

First is clarifying the IMF exchange rate surveillance principles. The fact is that the IMF has a good foundation of principles for members' exchange rate policies. These include the idea that "members should take into account in their intervention policies the interests of other members, including those of the countries in whose currencies they intervene." Moreover, the principles of Fund surveillance over exchange rate policies contain warnings against "protracted large-scale intervention in one direction" and "excessive" reserve accumulation.

These principles, which enjoy broad support among IMF membership, mandate active IMF involvement in exchange rate issues. And these principles are not new – they were spelled out in the late 1970s. Still, the principles of Fund surveillance could be sharpened with more procedural guidance on such issues as how long is "protracted" intervention? How much is "large-scale"? What constitutes and what are the costs of "excessive" build-up of reserves?

When the principles of surveillance were first drawn up, they were intentionally left vague so that experience could shape their interpretation. Nearly thirty years later, I believe we have that experience.

Second is improving the Article IV review, the core of IMF surveillance since the end of the Bretton Woods regime of fixed exchange rates. These reviews were originally designed to enable the IMF to exercise "firm surveillance" over the exchange rate policies of its members.

As I mentioned, assessing a member's balance of payments and its exchange rate regime and practices requires a comprehensive analysis of the general economic policies and performance of a country.

But my central point is that the pendulum has swung too far in Article IVs. In its bilateral surveillance, the Fund focuses very heavily on domestic economic developments and policies, especially fiscal policy, and addresses structural, demographic, and longer-term factors in considerable detail. These items are admittedly important. But increasingly what is missing is a thorough assessment of exchange rate issues.

Article IV reports need substantial and pointed discussions of exchange rate issues on a consistent basis. The IMF's Articles very reasonably allow a member to adopt the exchange rate regime of its choice. But at the same time, certain regimes may not be appropriate to a country's circumstances, and the Fund – with its wealth of expertise and experience across the globe – is well positioned to discuss this issue with authorities and advocate change. I propose four specific reforms to improve the quality of the foreign exchange element of the Article IV process.

1. Article IV reports should explicitly discuss the consistency of a country's exchange rate policy with domestic policies as well as the international system and the IMF's principles for members' exchange rate policies. The IMF should never accept uncritically a country's choice of exchange rate regime and simply posit what domestic policies or external circumstances would be required for the regime to be sustainable. Instead the Fund should ask tough questions, such as whether a fixed exchange rate is consistent with a realistic outlook for a country's fiscal policy, or increased integration into international capital markets.
2. Evaluation of exchange rate policies should consider whether alternative arrangements or regimes might be more appropriate. For example, flexible exchange rates are the clear choice for "larger" emerging markets. While not a substitute for sound domestic policies, currency flexibility can limit the one-way betting that results in rapid depletion of reserves; it better allows the external sector to bear a portion of the needed adjustment, rather than imposing an undue burden on domestic demand; and it provides signals of policy inconsistency in advance of crisis.
3. The IMF should improve its tools and advocacy to persuade countries to exit unsustainable exchange regimes early on, rather than waiting for perfect circumstances that never come. Too many countries wait until circumstances are dire before abandoning an inappropriate exchange arrangement, ratcheting up the costs to the country and to the global community. Earlier analysis and more forceful advice could help encourage smoother transitions.
4. Article IV reviews should draw more heavily from the Fund's World Economic Outlook and excellent multilateral analysis. Multilateral analysis should be integrated into and consistent with Article IV reports. This should result in better consideration of the international environment and improve the evaluation of specific country policies. So far visible progress along these lines has been made mostly in bilateral surveillance of the United States. Other countries – systemically important countries in particular – would benefit from this treatment.

In making these recommendations I am aware that some Article IV reports in the past have moved quite far in these directions. But this has not been consistent in scope or in tone, and there has been considerable ambiguity about the degree of shareholder support for such a robust role. It is time for the Fund – the only institution with a mandate to assure a smoothly functioning international monetary system – to reach judgments about the consistency of exchange rate policies with members' international obligations, and to do that consistently across the membership, particularly in systemically important countries. The Fund is not only a trusted advisor to each of its members but the protector of the system as a whole.

Third, we must finally de-stigmatize the special consultation mechanism. In 1979, the IMF developed a "special consultation" mechanism under which the Managing Director could consult with members whose exchange rate policies might not be in accord with the Fund's principles. Used only twice, revised in 1993 to broaden its application and promote greater use, but never used since – the special consultations mechanism is not working. There is nothing wrong with the concept of special consultations, but in practice the tool has been used so rarely that its use today would be perceived as a huge stigma for the country and might have market ramifications.

As a means of enhanced engagement in Article IV reviews, a process for more regular consultations should be undertaken to provide a realistic means of intensifying exchange rate surveillance. The regularity of this process could lessen the perceived stigma associated with special consultations, and encourage better compliance with IMF principles for exchange rate policies.

The procedures for these regular consultations should require the Managing Director to undertake intensified consultations pro-actively whenever an Article IV review raises serious questions about the compatibility of a member's exchange rate policy with IMF exchange rate principles or domestic policies, or when the exchange rate regime otherwise appears unsustainable. If such consultations have not been undertaken, the Executive Board should be able to call for them after reviewing the Article IV report and subsequently discuss the results of the intensified consultations.

Finally, multilateral surveillance should be enhanced. Since the 1980s, the IMF's multilateral surveillance has centered on the World Economic Outlook publication, which provides the Fund staff's globally consistent forecast and a broad view of trends that cut across countries and regions. Multilateral analysis can be extremely helpful by providing an overview of the global economy, and can be helpful for bilateral surveillance efforts, in particular, by identifying the ways local policies and systemic forces influence one another.

Considerable academic work, informal reasoning, and modeling have been applied to exchange rate determination. Many types of models exist, from a simple deviation from long-term averages to more state-of-the-art techniques. All of these models have critics. No approach or model has been able to predict exchange rate behavior, and we must be humble regarding our knowledge on this front.

It would be wholly unrealistic to think that countries would or could agree on what constitutes a precise "right" exchange rate level. Nor should the IMF be placed in the position of determining what the "right" exchange rate level is.

Nonetheless, quantitative efforts at exchange rate determination have helped enhance understanding of exchange rate issues, and I believe that multilateral surveillance could benefit from greater use of models and data that assess exchange rate trends. The presentation of many different estimates, using many different methodologies, alongside the relevant data, can be helpful in developing a qualitative assessment of a country's exchange rate policies and improving the information content for – and the functioning of – markets.

Therefore the IMF should deepen its work in developing techniques for assessing exchange rate behavior, extend this work more to emerging markets, and regularly publish its results. It should also seek to identify problematic or inappropriate exchange rate behavior. Some have said that publishing such data could trigger market instability. I do not agree. Properly presented, I think the routine publication of data would provide added information to reach fundamental judgments about exchange rate regimes.

To present the analysis, the Fund should have a regular report dedicated to exchange rate developments across many countries. This could take the form of a stand-alone report or an annex to the World Economic Outlook. In addition to presenting the foregoing data, the report would focus on analysis and assessments of exchange rate policies that contribute to the build-up of unsustainable bilateral or multilateral imbalances or that threaten to impede the orderly adjustment of imbalances. Furthermore, the Fund report should include its most current analysis on the conditions for exchange rate regime sustainability – including appropriate domestic and external circumstances for fixed regimes, floating regimes, and how to transition from one to another.

This report would achieve several goals. It would strengthen the IMF's focus on exchange rate surveillance and the resources it devotes to these issues. It could prompt debate, which could contribute to the development and refinement of analytical techniques. And the presentation of multiple models and judgmental interpretation of them would provide policymakers as well as market participants with a view of the richness and complexity of exchange rate dynamics – even for an individual currency. But most importantly, the report would facilitate identification of exchange rate policies that damage other members or pose a risk to the international financial system.

Taken together, these reforms would strengthen the IMF and improve the Fund's work as the preeminent monetary institution. As you know, the United States is engaged in discussions with certain countries regarding their exchange rate policies, and these discussions may color the interpretation of the surveillance reform proposals I have outlined today. Indeed, the IMF may fear being perceived as doing the bidding of the United States. But the ideas I proposed today go beyond immediate U.S. policy concerns. They are a reflection of the enduring concerns that led to the establishment of the IMF itself. I believe a strong IMF role on exchange rate issues is central to the stability and health of the international economy.

Thank you.