Strengthening the International Monetary System : Exchange Rates, Surveillance, and Objective Indicators

Andrew Crockett, and Morris Goldstein

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1987
• ISBN:
  9780939934768

NONE

Contents

Prefatory Note

I The System of Floating Exchange Rates: Review and Assessment

Perceived Weaknesses of Present System

Short-Run Volatility

Large and Persistent Misalignments of Real Exchange Rates

Lack of Discipline and Coordination in Macroeconomic Policies

Perceived Strengths of Present System

Promotion of External Payments Adjustment

Insulation from Inflation Abroad

Independence and Effectiveness of Domestic Monetary Policy

Resilience of Present System

Proposals for Improving Exchange Rate Stability

Target Zones for Exchange Rates of Major Currencies

Objective Indicators

Improvements Within Existing Institutional Setting

II Surveillance Over Exchange Rate Policies

Guidelines for Floating, 1974

1977 Document

Global Economic Environment, 1977

Lessons of Early Experience With Floating

Implications for Surveillance

Exchange Rate System Since 1977

Changing Policy Issues

Weaknesses in Working of Exchange Rate System

Implications for Surveillance Principles

Possible Modifications in Surveillance

Some Objectives

General Principles

Principles for Guidance of Members’ Exchange Rate Policies

Principles of Fund Surveillance Over Exchange Rate Policies

Procedures

III Indicators of Policies and Economic Performance

Purpose of Indicators

An Analytical Framework

Factors Influencing Balance of Payments

Criteria for Assessing Sustainability of Payments Balances

Types of Economic Indicator: Uses, Scope, and Limitations

Indicators of Economic Performance

Indicators of Economic Policy

Indicators of Intermediate Variables

Concluding Observations

APPENDIX

I Report of the Deputies of the Group of Ten: The Functioning of the International Monetary System

Chapter I: Introduction

Chapter II: The Functioning of Floating Exchange Rates

General Considerations

Assessment of Floating Exchange Rates

Proposals to Improve Exchange Rate Stability

Chapter III: Strengthening International Surveillance

General Considerations

Proposals to Strengthen Surveillance

Article IV Surveillance

Multilateral Surveillance

Chapter IV: The Management of International Liquidity

General Considerations

Proposals Concerning International Liquidity

Present and Future Role of the SDR

Chapter V: The Role of the IMF

General Considerations

Strengthening the Role of the IMF

IMF/IBRD Cooperation

Chapter VI: Summary and Conclusions

General Considerations

The Exchange Rate System

Surveillance

International Liquidity

The Role of the IMF

II Report of the Deputies of the Group of Twenty-Four: The Functioning and Improvement of the International Monetary System

Chapter I: Summary of Recommendations

The Functioning of the Present Exchange Rate System

Surveillance

Management of International Liquidity and the SDR

Role of the IMF

The Debt Problem and Transfer of Resources

Follow-Up Action

Chapter II: Introduction

Chapter III: An Overview of the International Economic Situation

Chapter IV: The Functioning of the Present Exchange Rate System

The Experience with Floating Rates

Proposals for Improving Exchange Rate Stability

Chapter V: Surveillance

The Objectives of Surveillance

The Analytical Basis of Surveillance

Pressures to Make Surveillance Effective

Enhanced Surveillance

Chapter VI: Management of International Liquidity and the SDR

Management of International Liquidity

The SDR

Chapter VII: Role of the IMF

Transitory Balance of Payments Problems

Persistent Imbalances Requiring Adjustment

Need for Concessionality in IMF Lending

The Volume of IMF Resources

Enlarged Access Policy and Access Limits

IMF/IBRD Collaboration

The Decision-Making Process

Chapter VIII: The Debt Problem and Transfer of Resources

Problems Relating to External Debt

Trade and Finance

Transfer of Resources to Developing Countries

III Executive Board Decisions on Surveillance Over Exchange Rate Policies

1977 Decision and Document

1979 Decision

References

The following symbols have been used throughout this paper:

. . . to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the time does not exist;

– between years or months (e.g., 1984–85 or January–June) to indicate the years or months covered, including the beginning and ending years or months;

/ between years (e.g., 1985/86) to indicate a crop or fiscal (financial) year.

“Billion” means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

Appendix I Report of the Deputies of the Group of Ten: The Functioning of the International Monetary System

Chapter I: Introduction

1. Following the invitation to Ministers of Finance recorded in the Declaration of the 1983 Williamsburg summit, the Ministers and Governors of the Group of Ten met in Washington on September 24, 1983 and had a preliminary exchange of views on the conditions necessary to improve the functioning of the international monetary system. They instructed their Deputies to met in the next few weeks “to identify the areas in which progressive improvements may be sought and to report to them at their next meeting to be held in early 1984.”

2. In compliance with those instructions, in November 1983 the Deputies outlined a work program, subsequently approved by the Ministers and Governors, which identified the following four areas for investigation:

a) The functioning of floating exchange rates.

b) Strengthening multilateral surveillance.

c) Management of international liquidity.

d) The role of the International Monetary Fund (IMF).

3. In the organization of their work, the Deputies decided to undertake the elaboration of policy papers themselves, and to request the preparation of background studies to the international institutions represented in the Group—namely the IMF, the Organization for Economic Cooperation and Development (OECD), the Bank for International Settlements (BIS), and the Commission of the European Communities. The Deputies had the benefit of hearing the views of a senior representative of the International Bank for Reconstruction and Development (IBRD) at one of their meetings.

4. The Chairman of the Deputies presented a progress report on the Deputies’ work to the Ministers and Governors at their Rome meeting on May 19, 1984. In the communique issued at the end of that meeting the Ministers and Governors “instructed their Deputies to continue their work, with a view to submitting a final report during the first half of 1985.”

5. Following this Introduction, Chapters II, III, IV, and V deal in turn with the four subjects of the work program. They present an analytical overview of the issues and of the Deputies’ discussions, including both the proposals on which a consensus was reached and those on which it was not. Chapter VI contains the Deputies’ conclusions and their recommendations to the Ministers and Governors.

Chapter II: The Functioning of Floating Exchange Rates

6. The Deputies have conducted a thorough examination of the working of the present system of floating exchange rates, taking stock of both the real experience acquired during the past decade and academic discussion. This chapter is devoted to a description and assessment of the system and to recommendations for improving its functioning, with a view to promoting greater exchange rate stability.

General Considerations

7. The present exchange rate system came into being against a background of unsound domestic policies and divergent economic performances resulting in wide inflation differentials and large and persistent payments imbalances which rendered the previous par value system unsustainable. The sharp rise in oil prices and the widely differing policy responses exacerbated these problems and placed added strains on the international financial system. Following a transitional period, a more flexible exchange rate system was agreed upon in the 1976 meeting of the Interim Committee in Jamaica, which recommended changes in the Articles of Agreement permitting countries to choose their exchange rate regime while imposing on them certain general obligations (see Article IV).

8. Inflation, external disturbances, and divergent economic performances continued to affect exchange market developments. The rapid expansion of international banking, the increasing sophistication and progressive deregulation of national financial markets, and the gradual removal of restrictions on capital flows have led to greater financial integration and capital mobility; while these developments may have contributed to short-term exchange rate movements, they have facilitated balance of payments financing and world economic growth.

9. Although most countries maintain some form of pegging, the main currencies all float separately or jointly against each other. These currencies are used to invoice and finance the bulk of world trade, are the basis for most of the Eurocurrency markets, and dominate foreign exchange trading. Over time, the system has evolved into a multicurrency reserve system in which the U.S. dollar is predominant while other main currencies have assumed secondary reserve roles. Since some three quarters of world trade and most invisible and capital transactions are conducted at floating rates, the present system can be described as a floating exchange rate system. In addition, regardless of their formal exchange rate arrangements, most countries have shown a greater willingness to let their exchange rates vary to prevent or to correct balance of payments disequilibria than under the par value system.

10. Since 1979 an arrangement which limits exchange rate fluctuations to narrow margins around agreed adjustable parities has been in operation within the context of the European Monetary System (EMS), involving a high degree of monetary cooperation and mutual surveillance. The arrangement is part of an effort to create an area of monetary stability and to achieve economic and monetary integration among countries closely linked by commercial flows as well as by institutional and political affinity.

11. The Deputies recognize that a country’s choice of exchange rate regime is influenced by a number of factors, including the scale, composition, and direction of its trade as well as its openness to capital flows. Consequently, the degree of exchange rate stability deemed appropriate differs from country to country.

12. While countries have freedom in their choice of exchange rate arrangements, they must meet certain obligations in connection with their exchange rate policies. These obligations are set out in Section I of Article IV of the IMF Articles of Agreement, which reads as follows: “Recognizing that the essential purpose of the international monetary system is to provide a framework that facilitates the exchange of goods, services, and capital among countries, and that sustains sound economic growth, and that a principal objective is the continuing development of the orderly underlying conditions that are necessary for financial and economic stability, each member undertakes to collaborate with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. In particular, each member shall:

i) endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances;

ii) seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions;

iii) avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members; and

iv) follow exchange policies compatible with the undertakings under this Section.”

The Deputies reaffirm the overriding importance of these principles and policies and of ensuring their full implementation.

Assessment of Floating Exchange Rates

13. It would be misleading to draw definite conclusions on the merits and demerits of the present system merely by comparing economic performance in the period of floating with that recorded under the par value system. Conditions during the floating rate period have been different in too many respects to allow such a comparison to be meaningful.

14. The Deputies agree that the existing exchange rate regime has shown valuable strengths. Exchange rate flexibility has made a positive contribution to external payments adjustment and to the maintenance of an open trade and payments system in a period of massive external shocks. It can help countries, especially the larger ones, to insulate their domestic price levels from inflation abroad, and can facilitate the pursuit of sound monetary policies geared more directly to domestic conditions. Furthermore, it is questionable whether any less flexible system would have survived the strains of the past decade, while attempting to preserve it would probably have led to increased reliance on restrictions on trade and capital flows.

15. The Deputies agree, however, that the functioning of the present system has also shown weaknesses. In particular the system has not adequately promoted sound and consistent policies. It has not prevented inadequate policies and divergent economic performances which have contributed to a high degree of short-term volatility of nominal exchange rates and to large medium-term movements in real exchange rates.

16. The Deputies have noted that short-term exchange rate volatility has been substantial and has not shown any tendency to diminish over time. Although empirical studies conducted by the IMF have been unable to find a significant systematic link between short-term exchange rate volatility and the volume of international trade, concern has been expressed that volatility may discourage investment and trade by adding to uncertainty and to financial risks for investors and traders. However, foreign exchange markets appear to have developed effective hedging techniques available to most operators to reduce the risks associated with exchange rate volatility, generally at comparatively little cost.

17. Changes in real exchange rates are appropriate when they facilitate desirable adjustments by reflecting changes in underlying economic conditions and inducing corrections in policies. However, large movements in real exchange rates may lead to patterns of international transactions that are unlikely to be sustainable and that can pose difficult problems for domestic economies, involving a risk of protectionist pressures building up and resources being misallocated. If these exchange rate movements are subsequently reversed, a further disruption of trade and investment may result over the medium term.

18. The Deputies have noted that the influence on exchange rates of financial transactions not directly related to trade flows has steadily increased during the past decade. In turn, exchange rate variability may have contributed to greater capital movements. As a result, exchange rate determination has been increasingly influenced by conditions in capital markets, including relative interest rates and expectations regarding the impact of national policies and current and future economic performance.

19. The Deputies recognize that some variability is inherent in freely floating exchange rates. Since trade flows tend to adjust more slowly than financial flows, the impact of changes in current conditions is first reflected in financial and foreign exchange markets. Furthermore, in an uncertain environment the difficulty of assessing policy stances and underlying economic fundamentals may lead markets initially to overreact to unexpected developments. Finally, structural rigidities, including legal and regulatory constraints, may distort exchange rate relationships and retard adjustment.

20. While some events affecting exchange rates have been beyond the immediate control of national authorities, the Deputies are of the opinion that exchange rate instability has been fueled by inadequate and inconsistent policies that have led to divergent economic performance. Expectations in financial markets that inappropriate policies might not be quickly corrected have sometimes resulted in large exchange rate movements. Moreover, the perceived instability in current and future policy courses has made it difficult for market participants to find an anchor for exchange rate expectations.

21. While their study of the functioning of the exchange rate system has focused primarily on the objective of achieving greater stability among floating currencies, the Deputies are fully aware that attempts to maintain exchange rates at levels not in line with economic fundamentals and market forces can be very damaging, both to the countries concerned and to their trading partners. They have expressed their strong support for efforts regularly made by the IMF to persuade countries to adopt realistic exchange rate policies.

22. Given the high degree of interdependence and financial integration in the world economy, the Deputies recognize that no exchange rate syste...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Prefatory Note
• I The System of Floating Exchange Rates: Review and Assessment
• II Surveillance Over Exchange Rate Policies
• III Indicators of Policies and Economic Performance
• APPENDIX
• References
• Footnotes