The Legal Foundation of IMF Surveillance

1. One of the key purposes in establishing the IMF was to promote “exchange stability” through a system of pegged but adjustable exchange rates. Article IV of the IMF Articles of Agreement initially stipulated that member countries consult with the IMF before adjusting the par values of their currencies beyond certain limits. The IMF, in turn, would concur only if it was satisfied that the proposed change was necessary to correct a “fundamental disequilibrium.”

2. In formally abolishing the par value system in 1978, however, the Second Amendment of the Articles allowed each member considerable (although not unlimited) freedom in choosing its “exchange arrange-ment”—the overall framework that a member uses to determine the value of its currency against other currencies (e.g., a decision to peg or float its currency). A member’s principal obligation under the amended Articles became that of collaborating “with the Fund and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates” (Article IV, Section 1).

3. In addition to this general obligation, members must observe four specific undertakings, two of which concern their domestic economic and financial policies, and two of which address their “exchange rate policies.” ¹ The two specific obligations respecting domestic policies are of a soft nature, requiring efforts rather than the achievement of results. They require the member to “endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability,” and to “seek to promote stability by fostering orderly underlying economic and financial conditions.” In contrast, the obligations respecting exchange rate policies require the achievement of results. In particular, these provisions require members to “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” (Article IV, Section 1).² The provisions of the amended Article IV recognize that the promotion of a “stable system of exchange rates” is most effectively achieved by members implementing appropriate exchange rate policies and domestic policies.

4. Article IV establishes obligations for the IMF as well. Under Article IV, Section 3(a), the IMF was given the responsibility to “oversee the international monetary system in order to ensure its effective operation,” and to “oversee the compliance of each member with its obligations under Section 1 of this Article.” Moreover, Article IV, Section 3(b) requires the IMF to “exercise firm surveillance over the exchange rate policies of its members.” Thus, the IMF was given the dual responsibility of exercising oversight over both the international monetary system and members’ obligations with respect to the conduct of their exchange rate and domestic economic and financial policies. Article IV also requires the IMF to “adopt specific principles for the guidance of all members with respect to” exchange rate policies. The first set of such principles was provided in the Executive Board’s 1977 Surveillance Decision, which took effect when the Second Amendment came into force.³

Guidance for the Implementation of IMF Surveillance

5. The 1977 Surveillance Decision provides guidance to members in the conduct of their exchange rate policies under Article IV, Section 1 and to the IMF in the exercise of surveillance over those policies. It states, among other things, that the “surveillance of exchange rate policies shall be adapted to the needs of international adjustment as they develop” and that the “Fund’s appraisal of a member’s exchange rate policies shall be based on an evaluation of the developments in the member’s balance of payments, including the size and sustainability of capital flows, against the background of its reserve position and its external indebtedness.” The IMF Executive Board has since elaborated on the 1977 Surveillance Decision on several occasions, including during a discussion on “Exchange Rate Regimes in an Increasingly Integrated World Economy” held in 1999. The Chair’s Summing Up of the discussion stated that “the Fund should offer its own views to assist national authorities in their policy deliberations” on exchange rate policy and “seek to ensure that countries’ policies and circumstances are consistent with their choice of exchange rate regime.” ⁴

6. A number of basic concepts may be derived from Article IV and the 1977 Surveillance Decision, which may be summarized as follows:

• First, no single exchange rate regime is best for all countries in all circumstances.

• Second, a member country may choose the exchange rate regime that it intends to apply to fulfill its obligations under Article IV, Section 1, subject to a few limitations; and the IMF generally abides by the member’s regime choice.

• Third, while considering the choice of regime to be a matter for each member country, the IMF seeks to provide clear and candid advice to members on the consistency of that regime with the member’s national policies and circumstances as well as with members’ obligations under the Articles of Agreement.

• Fourth, analysis and policy advice on exchange rate matters should be framed in the context of the general economic situation and policy strategy of the member.

7. Providing advice on the basis of these principles necessarily requires analysis of two closely related issues: (1) exchange rate regime choice and suitability, and (2) appropriateness of exchange rate levels.⁵ This, in turn, covers the following dimensions, as recognized in recent Biennial Surveillance Reviews:

• Regime identification. It is essential for staff to accurately identify and describe the de facto exchange rate regime in place in a particular coun-try, as regime identification is a prerequisite for providing the right context for policy advice. For their part, members are required under Article IV, Section 2 to notify the IMF of their “exchange arrangements” and of any changes thereto.

• Regime assessment. Assessment of the (continued) suitability of the chosen regime, given policy objectives and the economic environment, on the basis of certain criteria; staff would assess regimes in all cases and would be expected to discuss the appropriateness of an exchange rate regime if there were doubts about its conduciveness to macroeconomic stability.

• Level assessment. Assessment of the exchange rate level, regardless of the exchange rate regime in place, including a thorough assessment of external competitiveness.

• Consistency. Both exchange rate regime and valuation are to be discussed in terms of consistency with other economic policies, external stability consid-erations, and the country’s external and domestic policy goals.

8. The Policy Development and Review Department’s Surveillance Guidance Notes provide principal guidance for the practical implementation of these surveillance principles. These notes incorporate the 1977 Surveillance Decision and the results of any subsequent surveillance reviews and are intended to make them operational. The latest note was issued in May 2005 and superseded the previous guidance notes. While the first of PDR’s guidance notes had emphasized the need to focus staff reports on the core area of exchange rate policies, the subsequent notes elevated the need to pay selective attention to other relevant macroeconomic and structural policies as equally important. The 2004 Biennial Surveillance Review added to previous attempts to prioritize by calling for a focus on issues at the “apex of the Fund’s hierarchy of concerns,” such as external sustainability, vulnerability to balance of payments crises, and international spillovers of policies in large economies. As critical steps of exchange rate surveillance, moreover, it underscored “clear identification of the de facto exchange rate regime in staff reports; more systematic use of a broad range of indicators and other analytical tools to assess external competitive-ness; and a through and balanced presentation of the policy dialogue between staff and the authorities on exchange rate issues.” ⁶

The Process of IMF Surveillance

9. Exchange rate surveillance is conducted through various vehicles, most frequently the IMF’s regular Article IV consultation process.⁷ Surveillance is con-tinuous. For each “cycle,” however, the process of analyzing and providing advice on members’ exchange rate policies can be represented by a stylized, multistage “results chain” that connects “inputs” with IMF activities and their outcomes. Figure A1.1 depicts the three main (partially overlapping) stages of this pro-cess: (1) analysis and assessments; (2) communication of policy advice (including review by the Executive Board); and (3) follow-up, including continuous monitoring between cycles. Each stage embodies bilateral and multilateral components, which are considered to be two complementary perspectives inherent in any surveillance activity.

The Provision of IMF Exchange Rate Policy Advice

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The Provision of IMF Exchange Rate Policy Advice

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10. At the first stage, IMF staff assess the appropriateness and sustainability of a country’s exchange rate policy (e.g., both the regime and the prevailing level), by taking into account its compatibility with the country’s overall policy environment and external conditions. Staff also analyze the global and regional implications of policies pursued by systemically more important countries, as well as resulting implications for individual member countries. Bilateral and multilateral assessments inform each other. In this, the IMF’s dual mandate (as overseer of members’ compliance with their obligations and of the international monetary system) effectively requires consistency between the two types of assessments.

11. Once staff and management have come to a particular view, their assessment is provided to the Executive Board for its consideration under the Board’s surveillance responsibility; ultimately, the views expressed by the Board become “official” IMF views for the purposes of surveillance. A key input into these assessments, and the starting point of the surveillance process, is the provision of relevant information by national authorities—including information that is required under Article VIII, Section 5—the availability and quality of which may affect the overall effectiveness of policy advice. Another requirement is the correct identification by staff of the exchange rate regime in place, which is a prerequisite for providing the right context for accurate policy advice.

12. At the second stage, once a position on a particular issue is formed, it needs to be communicated to the relevant audience. Unless engaged in a program relationship with the respective country, the IMF relies largely on persuasion and peer pressure to influence national policies, using different channels: bilateral discussions at the staff level, review at the Board level, national and international policy debate, and—possibly—through publication of the channel of accountability via public opinion and the disciplining role of markets. To be effective, the IMF must use the most appropriate channel(s) for a particular message, recognizing that communication with the authorities of members is the primary channel; that some information is market sensitive; and that analytical and practical difficulties in generating reliable assessments of exchange rate issues invariably lead to significant margins of error.

13. At the third and final stage, the advice given must be followed up, in view of the actual or prospective actions taken by national authorities and in light of subsequent domestic and international developments. These assessments will feed into the next surveillance cycle and may also be reflected in other aspects of IMF operations, such as technical assistance or IMF-supported programs. To follow up on its advice for greater exchange rate flexibility, for example, the IMF may provide technical assistance on developing an appropriate institutional framework, possibly including any legal and operational aspects of implementation. Regardless of whether specific advice is given, the IMF must monitor developments continuously until the next “cycle” begins.

Exchange rate regime

2. Board views cover several aspects of exchange rate regimes, including regime choice, regime classifi-cation, preferred regime, and inflation targeting.

• Choice. During the 2002 Biennial Surveillance Review (BSR), Directors welcomed the increased candor with which “soft” exchange rate pegs were assessed in countries with access to international capital markets. They noted, however, that exchange rate arrangements were not questioned in many other cases, and urged the staff to treat “exchange rate issues” candidly in all countries.¹

• Classification. In the 1999 Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER), the IMF staff changed its regime classification from a de jure (as reported by the members) to a de facto basis. The Executive Board, however, made no call for using the de facto classification in Article IV consultations until 2004.² Directors noted that a clear and candid treatment of exchange rate issues remained a challenge, and recommended the identification of de facto regime as a first step to address this challenge.

• Preferred regime. During the evaluation period, the Executive Board did not fully endorse the bipolar view of exchange rate policy that management and staff seemed to express from time to time.³ The Board, while acknowledging the challenges posed by increasing capital mobility, supported intermediate regimes as viable alternatives.⁴ In the context of the 2004 BSR, Directors reiterated the idea that “no exchange rate regime is appropriate for all countries or for all circumstances” and stressed that discussion of exchange rate issues should permit consideration of a variety of options and take full account of country-specific circumstances.

• Inflation targeting. The Board has not fully endorsed the merits of greater exchange rate flexibility with inflation targeting—a monetary policy regime that management and staff has pursued in more recent years.⁵ In discussing the paper “Inflation Targeting and the IMF,” the Board as recently as 2006 noted that a number of preconditions remained important for success; many Directors, moreover, stated that “adoption of inflation targeting should not be seen as a macroeconomic panacea” and that inflation targeting may not be appropriate in all cases.⁶

Exchange rate level

3. The views of the Executive Board on exchange rate level refer both to the need for level assessment and to the CGER methodology used by the staff for such assessment.

• Assessing the level. In discussing the 2000 BSR, most Directors “stressed that an assessment of…the exchange rate level is to be made in all cases,” while recognizing the risk that explicit judgments in staff reports on the exchange rate level could exert an undue and disruptive influence on markets.⁷ During the 2004 BSR, the Board called for the use of a broad range of indicators and other analytical tools to assess external competitiveness.⁸

• Methodology. In the discussion of a methodological note ⁹ produced by the Consultative Group on Exchange Rate Issues (CGER) in 2001, the Board welcomed the improvement made since 1997 and its prospective extension to emerging markets. While noting the contribution of the CGER methodology as a tool of ensuring global and temporal consistency, however, it recognized the dominant role of subjective judgment and therefore called for a judicious use of equilibrium exchange rate estimates in Article IV consultations.¹⁰ Directors also stressed that further work was needed before CGER assessments could be used consistently in emerging markets.

Spillover issues—intervention and exchange rate manipulation

4. The Executive Board increasingly stressed the need to pay attention to global and regional spillovers, but gave little guidance on issues related to official foreign exchange market intervention during this period.

• Global and regional issues. Though not specific to exchange rate issues, the Executive Board on several occasions called for greater attention to cross-country issues and policy interdependence. During the 2002 BSR, for example, many Directors stressed that “the spillover effects of policy changes in systemically important countries on other economies need to be more carefully explored.” The discussion of the 2004 BSR called for fuller treatment of the global impact of domestic policies in the largest members.

• Intervention and exchange rate manipulation. Both the Articles of Agreement and the 1977 Surveillance Decision contain a specific provision prohibiting members from manipulating exchange rates in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.¹¹ It is not easy to make a case for exchange rate manipulation because it would require the IMF to establish the intent of a particular exchange rate practice. The Board, however, has not made use of the procedures to discuss such issues—special and supplementary consultations—that could have been used during this period.¹²

Financial stability

5. Financial stability issues assumed greater importance during the period, with balance sheet analysis becoming part of the toolkit of IMF surveillance. During the 2000 BSR, Directors noted that “all issues related to external sustainability and vulnerability to balance of payments or currency crises will continue to be at the apex of this [surveillance] hierarchy.” During the 2004 BSR, Directors stressed that the “current strategy to improve vulnerability assessments and balance sheet analysis is having a positive impact, and urged staff to continue refining the analytical techniques, while recognizing data constraints.” ¹³

The locus of surveillance

6. Despite the fact that the Executive Board is the main locus of surveillance, market sensitivity and other confidentiality concerns may dictate that the Board is kept out of some issues that are being discussed between staff/management and national authorities. This issue was raised during the 2000 BSR, when some Directors suggested that the staff should explore using an alternative mechanism (such as oral presentation) to communicate their views to the Board when an explicit statement in a staff report could lead to market instability. In subsequent Board discussions, the concerns of Directors have focused more narrowly on point estimates of equilibrium exchange rates or the size of currency misalignment. Directors have also expressed concern about the de facto classification of exchange rate regimes in some cases.

Transparency policy

7. Although Board advice on transparency became increasingly detailed during 1999–2005, some tension between transparency and candor persisted. During the 2005 Review of the IMF’s Transparency Policy, most Directors were satisfied with the finding that an increased rate of publication of Board documents had not led to a significant erosion of candor,¹⁴ but other Directors interpreted the finding as “distinct evidence of a loss of candor associated with the current publication policy.” Although the majority of the Directors agreed with staff recommendations for improving the timeliness of publication, preserving candor, and reducing implementation costs, other Directors were concerned that some of the proposed changes could undermine the efforts to increase the publication rate or that strict enforcement of the publication guidelines could affect the balance between candor and greater openness or else compromise the quality of staff reports.

8. The policy on deletions in Board documents remained broadly unchanged during the period. The deletions policy, however, was occasionally challenged by some Directors, particularly regarding politically sensitive material (which is not contemplated in the policy). During the 2003 Review of Transparency Policy, many Directors favored the extension of the deletions policy to politically sensitive material but the Board did not approve the move; the majority of Directors pointed to the difficulty of designing an objective test of what is “highly politically sensitive” and to the risk of undermining the candor and comprehensiveness of Board documents. During the 2005 Review of Transparency Policy, some Directors considered that the deletion of politically sensitive issues that fall outside the current policy would “help better reconcile the objectives of candor and transparency”—although no amendment to the policy was made.¹⁵

Policy dialogue and outreach

9. Though not specific to exchange rate issues, Directors stressed during the 2004 BSR the importance of a close and frank policy dialogue between the IMF and its members, and encouraged countries to prepare policy statements (which would be an input to policy discussions); frequent contacts outside the Article IV consultations; and greater continuity of staff assignments to promote the accumulation of country-specific knowledge. Directors also supported the staff proposal to produce a one-page note to enhance communications with senior policymakers as a complement to the Article IV mission’s concluding statement. At the same time, Directors encouraged staff to develop outreach programs and enhance contacts with local think tanks.

The fundamental equilibrium exchange rate (FEER)

4. The FEER is defined to be the exchange rate that is consistent with both internal and external balance simultaneously (see Williamson, 1994, for details). Internal balance is reached when the economy in question is at the full-employment level of output at stable prices, while external balance is characterized as a balance of payments position sustainable over a medium-term horizon. Because it is difficult to identify the level of potential output, it is often assumed that the adjustment process assures internal balance when external balance is achieved. Then, the FEER is found by a two-step procedure: (1) identifying the components of the current account balance as a function of the real effective exchange rate; and (2) solving for the equilibrium real effective exchange rate by imposing macroeconomic balance.

5. As an illustration of the FEER approach, let us decompose the current account (CA) into two com-ponents: the net trade balance (ntb) and returns to net foreign assets (nfa), where ntb is a function of the real effective exchange rate (q^REER) and the outputs of the domestic and foreign economies (yd and yf); and nfa is also influenced by the real effective exchange rate (because an accumulation of net foreign liabilities would have to be financed). It will be necessary under these assumptions for the currency to depreciate in order to improve the trade balance and the net foreign asset position. Assuming full employment, we have:

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where ${\overline{y}}_{d}and\overline{y_f}$ are the full employment outputs of the respective economies. On the capital flow side, most applications of the FEER assume that the equilibrium capital account over the medium term, denoted as $\overline{KA}$ is exogenously determined (Williamson, 1994; Bayoumi and others, 1994). Then, by imposing external balance ($(CA=-\overline{KA})$), we obtain the equilibrium real exchange rate (q^FEER) as:

View Expanded

6. Additional factors can easily be accommodated in this framework. For example, the FEER can incorporate the impact of a potential difference in productivity growth between the two economies. This is the well-known Balassa-Samuelson effect. In this case, it becomes similar to the so-called adjusted purchasing-power-parity (PPP) approach (which adjusts the simple PPP approach for changes in the relative price of traded and nontraded goods, commodity terms of trade, or net foreign asset position). The key point is that, unlike the simple PPP approach, the FEER approach allows the equilibrium exchange rate to move as fundamentals change.

The behavioral equilibrium exchange rate (BEER)

9. The BEER approach decomposes the variables that determine the real exchange rate into long-term economic fundamentals (Z^t) and short-term real interest rate differentials. Unlike the FEER approach, it does not consider macroeconomic balance and there-fore uses the current values (rather than full employment values) of economic fundamentals in defining the equilibrium real exchange rate. The key elements of the BEER approach are: (1) a set of long-term economic fundamentals (which could include the terms of trade, net foreign assets, relative government debt, productiv-ity, and the like); and (2) uncovered interest rate parity (UIP), which is assumed to determine the short-term (cyclical) behavior of the exchange rate.

10. To see how the model works, let us express UIP as follows:

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where E_t(e_t+1) denotes the expected value formed in period t of the nominal exchange rate in period t+1; e^t is the nominal exchange rate in period t, defined in terms of domestic currency per unit of foreign currency; and i^t and $i_t^{*}$ refer to the domestic and foreign nominal interest rates, respectively. By subtracting the expected inflation differential from both sides, equation (3) can be rearranged to yield the observed real exchange rate (q^t) as a function of the expected real exchange rate E^t(q^t+1) and the current real interest rate differential ($(T_t-r_t^{*})$). Assuming that the unobservable expected real exchange rate E^t(q^t+1) is determined solely by long-run economic fundamentals (Z^t), one can then estimate the BEER $(q_t^{BEER})$ by making use of its functional relation ship to the vector of the chosen fundamentals and the real interest rate differential:

View Expanded

11. Several studies have applied the BEER approach in recent years, including Clark and MacDonald (1998); Koen and others (2001); Detken and others (2002); and Maeso-Fernandez, Osbat, and Schnatz (2002). Clark and MacDonald (1998), for example, used three variables as long-run economic fundamentals (Z^t): the terms of trade, the relative price of nontraded to traded goods (which captures the Balassa-Samuelson effect), and the balance of net foreign assets. These authors, however, modified UIP by adding a risk premium, which they assumed to be time-varying depending on the ratio of domestic to foreign government debt. Because the BEER uses the current values of economic fundamentals (without making a distinction between short-term and long-term equilibrium values), any identified exchange rate misalignment is often referred to as the current misalignment.

The natural real exchange rate (NATREX)

14. The NATREX is defined as the exchange rate that would prevail if speculative and cyclical factors were removed while unemployment was at its natural rate (Stein, 1994; Allen, 1995). As a distinguishing feature, the NATREX approach explicitly considers exchange rate dynamics. In particular, it postulates that the real exchange rate, observed at time t, consists of the following three components:

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where k is the stock of capital, F is the stock of external debt, e is a random error (which is assumed to capture speculative forces), and Z is a vector of fundamentals. The first term on the right-hand side represents the deviation of the current (short-term) exchange rate from the medium-term value; the second term denotes the deviation of the medium-term real exchange rate from the long-term equilibrium value; the last term is the long-term equilibrium exchange rate that is determined solely by economic fundamentals, which are defined as productivity and time preference (or “social thrift”) at home and abroad.

15. The NATREX corresponds to the medium-term real exchange rate, given by q = q(k^t,F^t:Z^t). Unlike the short-term rate, it is independent of speculative factors; it is, however, specific to the given stocks of capital and debt. In contrast, the long-term real exchange rate is represented by q^* = q^*(Z^t). This is the rate that materializes when the stock of capital and the stock of debt converge to their steady-state values consistent with the prevailing economic fundamentals. The fundamentals are the only exogenous variables in the long run.⁶ The fundamentals, however, may not be stationary. They can also change, thus affecting not only the levels of desired investment, saving, and the current account, but also the trajectory of the NATREX by bringing about changes in capital formation, the rate of debt accumula-tion, and the interest rate.

16. In considering the determination of the medium-term real exchange rate, the NATREX approach pays particular attention to investment, saving, long-term capital flows, and the resulting changes in the stocks of real physical capital, wealth, and net debt to foreign-ers. In the hypothetical medium run, it is assumed that prices have adjusted, output has returned to its potential level, and desired national investment equals desired national saving, which depends on the stocks of capital, wealth, and debt. To the extent that these stocks change, the NATREX is a moving equilibrium. The architects of this approach claim that the NATREX is “an artificial construct” toward which the actual exchange rate tends to adjust. It is not observable, and it “never actually prevails” (Allen, 1995).

17. The empirical application of the NATREX approach is much simpler than the theory implies and, as stated ear-lier, is often indistinguishable from the BEER approach. The NATREX is estimated by identifying a long-run cointegrating relationship between the real exchange rate and a set of fundamentals (usually productivity and time preference), for which appropriate proxies are selected; an error correction term is included to capture the trajectory of the real exchange rate toward the NATREX. In actual estimation, no distinction is made between the medium run and the long run, because the fundamentals never obtain their steady-state values. The theory is then used to explain why the real exchange rate has moved in a certain way and to predict how it might yet change over time. For example, a medium-term appreciation of the real exchange rate might be consistent with a rise in government expenditure, which raises aggregate demand and worsens the current account position. The theory then suggests that a depreciation of the real exchange rate is needed to stabilize the balance of net foreign assets in the longer run.

The CGER framework

28. As one of the two pillars of the CGER exercise, the macroeconomic balance approach is based on the concept of equilibrium that is similar to that of the FEER, that is, the achievement of internal and external balance.¹⁴ Internal balance means full employment with stable prices, while the notion of external balance relates to the link between the current account and the saving-investment balance, as follows:

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The key objective of the CGER macroeconomic balance model is to assess whether the outlook for the underlying current account (UCUR) position, captured by the net trade balance (X–M) at the prevailing exchange rate, is consistent with the “normal” or equilibrium saving-investment balance (S–I). If the current account position corresponds to the equilibrium saving-investment balance, the prevailing exchange rate is the “medium-term” equilibrium exchange rate. Otherwise, there is a possible misalignment of the currency.

29. This CGER framework can be depicted in a simple diagram (Figure A3.1). The UCUR line slopes downward, indicating that the current account position improves when the domestic currency depreciates (cap-tured by a lower real effective exchange rate level). The slope of UCUR also reflects the degree of economic openness. Countries with a high ratio of exports and imports to GDP should have a relatively flat UCUR line, indicating that a small percentage change in the real effective exchange rate can bring about a large change in the underlying current account position.

The Underlying Current Account Position and the Saving-Investment Balance

Source: Isard and others (2001).

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The Underlying Current Account Position and the Saving-Investment Balance

Source: Isard and others (2001).

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The Underlying Current Account Position and the Saving-Investment Balance

Source: Isard and others (2001).

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30. The medium-term saving-investment balance (S-I), on the other hand, is not a direct function of the real effective exchange rate. If the economy is at R₁, the underlying current account position is less than the saving-investment balance position. The real effective exchange rate then must depreciate to R^* in order to improve the current account position to the medium-term equilibrium level. In other words, given the current economic fundamentals, the prevailing real effective exchange rate is overval-ued, and is expected to depreciate to R^*. In addition, driven by shocks to their fundamental variables, both the UCUR line and the S-I line may shift to the right or the left.

The CGER estimation

31. Four steps are involved in calculating the medium-term misalignment of a currency. The first step is to estimate the underlying current account (UCUR) position that would emerge at the prevailing exchange rate if all countries were producing at their potential output levels and the lagged effects of past exchange rate changes had been fully realized. Here, we focus on the right-hand side of equation (6).

32. As an estimate of UCUR, the CGER uses forecasts obtained from the World Economic Outlook (WEO) exercise. For most countries, the WEO forecasts the underlying current account balances by assuming that the real exchange rate will remain unchanged and that the economy will be operating at potential output at the end of the five-year WEO horizon. The primary advantage of the WEO approach is that it incorporates the country-specific knowledge and judgments of the IMF’s area department staff.

33. Once the underlying current account is obtained, the second step involves generating the “medium-term” equilibrium saving-investment balance or “norm.” Two alternative estimating approaches are used. First, the saving-investment balance is regressed against a set of commonly considered fundamental determinants over a number of years. The fundamental determinants for industrial countries include fiscal balance, income per capita, output gap, and a demographic factor. For the developing economies, a more extensive set of fundamental variables is considered (see Chinn and Prasad, 2003). The estimated regression coefficients would yield the average medium-term equilibrium saving-investment balance. Second, as an alternative method, the “norm” saving-invest-ment balance is obtained by estimating the current account balance required to maintain a constant ratio of net foreign liabilities to GDP.

34. The third step is to calculate how much the exchange rate would have to change, other things remaining unchanged, in order to equilibrate the underlying current account to the medium-term equilibrium saving-investment balance. Incorporating the coefficient estimates from the first two steps, a globally consistent framework is used to calculate the required changes in the multilateral or bilateral exchange rate.

35. The last step involves comparing the results with those from the adjusted PPP approach which has also been applied multilaterally by using panel data. The staff then use subjective judgment to assess whether or not the currency is misaligned and the extent of misalignment when identified. Considerable uncertainty surrounds the estimates of the CGER or any other equilibrium exchange rate models. If there is a large discrepancy between the results obtained from the competing approaches, a range of values is provided for the potential deviation of the currency from the equilibrium level.

Features of the CGER approach

36. Undoubtedly, the single most important advantage of the CGER approach over other equilibrium exchange rate models in the literature is its explicitly multilateral character, which imposes global consis-tency. At the same time, the multilateral orientation comes with a cost, because it becomes more difficult to understand how a particular result is being generated. There is considerable uncertainty about the estimates generated from any equilibrium exchange rate model. But given the additional multilateral layer, uncertainty is likely greater in the CGER approach.

37. Some limitations of the CGER exercise are well known (Isard and others, 2001). First, the CGER exercise, unlike the NATREX model, is not explicit about the dynamics of exchange rate adjustment from the current value to the longer-term equilibrium. Second, the CGER exercise, given its global orientation, does not consider country-specific factors. The limitations are true of both the macroeconomic balance approach and the adjusted PPP approach, both of which rely on the cross-country estimates generated from panel data regression (which render the estimated relationship an average relationship across countries). ¹⁵

38. Third, the CGER’s macroeconomic balance model assumes that countries have unlimited access to international capital markets at a constant premium over the world interest rate, which may become a particularly serious problem in estimating a medium- to long-term equilibrium exchange rate for an emerging market economy. Fourth, the assumption that the “norm” saving-investment balance is independent of the current exchange rate is also restrictive, especially for emerging market economies.¹⁶ Fifth, the underlying model assumes that, for the purpose of estimating the size of possible misalignment, the real exchange rate is the only mechanism to bring about current account adjustment. This may create upward bias in the required real exchange rate change because other variables are likely to change in practice to facilitate the adjustment.

39. Isard and others (2001) noted that, as is typically the case with most applications of the FEER-type model, the estimates of the macroeconomic balance model are quite sensitive to small changes in the assumptions. This means that there is considerable uncertainty about the confidence with which one can assess the degree of misalignment of a currency. As the architects of this approach suggest, one would need to exercise judgment in coming to a particular assessment. This is true of all equilibrium exchange rate models, but the sensitivity associated with the CGER’s macroeconomic model calls for caution, a point being addressed in part by the complementary use of two alternative methodologies by the exercise.

40. Given not only the limited sample size but also the nature of the exercise, it is not possible to conduct rigorous statistical tests of the CGER estimates.¹⁷ The available evidence, however, suggests that the application of the CGER approach has sometimes yielded a widely divergent set of estimates. A look at the time-series of selected CGER results indicates that the range of estimates for a given currency for a given year can be large in terms of deviation from the equilibrium value, and that the range has increased sharply from around 2004 for most currencies (see Figure A3.2 for examples).¹⁸ Moreover, it has occasionally been observed that the two methodologies can indicate misalignment in two opposite directions (e.g., one showing undervaluation, while the other indicating overvaluation) and that the CGER estimates even missed the direction of prospective exchange rate movements altogether.

Examples of CGER Estimates, 2000–06

(In terms of percentage deviation from medium-term equilibrium levels)

Note: The limits indicated by a vertical bar correspond to the CGER estimates produced by the two approaches for each year. Each bar has (left and right) ticks that correspond to the final CGER assessment.

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Examples of CGER Estimates, 2000–06

(In terms of percentage deviation from medium-term equilibrium levels)

Note: The limits indicated by a vertical bar correspond to the CGER estimates produced by the two approaches for each year. Each bar has (left and right) ticks that correspond to the final CGER assessment.

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Examples of CGER Estimates, 2000–06

(In terms of percentage deviation from medium-term equilibrium levels)

Note: The limits indicated by a vertical bar correspond to the CGER estimates produced by the two approaches for each year. Each bar has (left and right) ticks that correspond to the final CGER assessment.

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41. The fact that the sets of CGER estimates have sometimes been widely divergent from each other (or even missed the prospective currency movement) does not by itself render them useless. After all, it is well known that exchange rates can deviate substantially from their long-term fundamental values in the short run. The CGER is not a forecasting exercise and does not claim to trace the short-term currency movements. Even so, these factors may explain the skepticism that exists among some IMF staff ¹⁹ and the (appropriate) judiciousness with which area department economists have applied the CGER estimates in their country work.

Exchange rate level assessments

42. The IEO’s review of the two most recent Article IV consultation reports for all members through 2005,²⁰ supplemented by a screening of the remaining staff reports and accompanying selected issues papers for the period 2000–05,²¹ indicates REER indices have been the main tool of exchange rate level assessment in IMF surveillance: REER charts were included in all Article IV reports reviewed and, in most cases, there was at least a brief commentary on the movements of the REERs. Going beyond the REER charts, IMF staff provided additional exchange rate level analysis for up to 14 percent of the Fund membership in any given year since 2000 (see Table A3.1 and Figure A3.3). The documents covering the remaining countries did not explicitly use quantitative approaches to estimate the equilibrium exchange rate. A few of the documents, however, cited the findings of separate analyses, including the IMF’s own working papers, central bank stud-ies, and periodic reports of investment banks, in making exchange rate level assessments.²²

Table A3.1.

Use of Multiple Methods in the Assessment of Exchange Rate Levels by the IMF, 2000-05

Note: Based on staff papers and related documents issued between January 2000 and December 2005. The coverage thus differs slightly from the review of country documents presented in Background Document 4. See Annex A3.1 for details.

Table A3.1.

Use of Multiple Methods in the Assessment of Exchange Rate Levels by the IMF, 2000-05

	Number of Methods
Year	1	2	3	Number of Countries
2000	14	0	0	14
2001	15	2	0	17
2002	21	2	0	23
2003	12	6	0	18
2004	22	3	1	26
2005	16	7	2	25

Note: Based on staff papers and related documents issued between January 2000 and December 2005. The coverage thus differs slightly from the review of country documents presented in Background Document 4. See Annex A3.1 for details.

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Table A3.1.

Use of Multiple Methods in the Assessment of Exchange Rate Levels by the IMF, 2000-05

	Number of Methods
Year	1	2	3	Number of Countries
2000	14	0	0	14
2001	15	2	0	17
2002	21	2	0	23
2003	12	6	0	18
2004	22	3	1	26
2005	16	7	2	25

Note: Based on staff papers and related documents issued between January 2000 and December 2005. The coverage thus differs slightly from the review of country documents presented in Background Document 4. See Annex A3.1 for details.

Methodologies Used in the IMF’s Exchange Rate Level Assessment, 2000–05

(Total number)

Note: See Annex A3.1 for details.

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Methodologies Used in the IMF’s Exchange Rate Level Assessment, 2000–05

(Total number)

Note: See Annex A3.1 for details.

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Methodologies Used in the IMF’s Exchange Rate Level Assessment, 2000–05

(Total number)

Note: See Annex A3.1 for details.

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Note: Based on staff papers and related documents issued between January 2000 and December 2005. The coverage thus differs slightly from the review of country documents presented in Background Document 4. See Annex A3.1 for details.

43. Besides the ubiquitous REER charts, the most commonly applied tools were the simple PPP approach and the adjusted (or augmented) PPP approach; the latter was usually used as part of a CGER exercise. The estimates from the CGER approach were frequently reported, particularly in most discussions of the currencies of industrial countries, but also increasingly in the case of some emerging and developing countries. Among the equilibrium exchange rate models that were reviewed in the section “Alternative Approaches to Modeling the Equilibrium Exchange Rate” above, the BEER and its variants appear to be the most frequently employed by the IMF staff, particularly for the currencies of emerging market economies. A test of long-run cointegration between the real effective exchange rate and a selected set of fundamentals is usually carried out to estimate the equilibrium exchange rate and the degree of misalignment. In some cases, an error correction term is added to explain the short-term deviation of the exchange rate from its equilibrium value.

44. For example, IMF staff used a BEER model to assess the level of the Tanzania shilling in 2002 (supple-mented by the PPP approach) as well as in 2004. The staff specified the BEER as a function of the terms of trade, productivity, government consumption, trade openness, and foreign capital flows and concluded that the shilling, slightly overvalued at end-2001, gradually moved toward equilibrium and, by 2003, was broadly in line with the equilibrium level. For Madagascar in 2005, IMF staff used both FEER and BEER models. The staff specified the long-run FEER in terms of three fundamentals: productivity, net wealth, and the terms of trade, and considered that shocks to these fundamentals and the stance of monetary and fiscal policies determined the deviation of the actual real exchange rate from the FEER. In this framework, the BEER was estimated as the sum of the FEER and the deviation explained by the nonfundamental variables. Based on data for 1980–2003, the staff concluded that, at the end of 2004, the real effective exchange rate of the Malagasy franc was below both the FEER (by about 20 percent) and the BEER (by about 27 percent). For Hungary in 2004, the staff specified the equilibrium real exchange rate as a function of net foreign assets and industrial sector productivity,²³ and used this model to conclude that the Hungarian forint, undervalued in the second half of the 1990s, became overvalued in the early 2000s but returned to its equilibrium level in late 2003.²⁴

45. Figure A3.3 indicates that, regardless of which methodology was used, use of quantitative models in the IMF’s exchange rate surveillance has increased over the period. The increasing sophistication of exchange rate level assessments by the IMF staff has largely reflected the greater use of the PPP or adjusted PPP approach and the FEER/BEER methodologies. On the other hand, there has been little change in the frequency of references to CGER estimates or use of macroeconomic balance approaches (other than the FEER).²⁵ A closer look indicates that the use of multiple methods has increased somewhat over the years, though it remains rather limited in absolute terms (see Table A3.1).

The characteristics of the IMF’s exchange rate level assessment

46. The IMF’s country documents reviewed here differ widely in their quality, rigor, and comprehensiveness of analysis. In most cases, the IMF’s exchange rate level assessment primarily attempts to identify evidence of improvement or deterioration in competitiveness on the basis of consumer-price-index-based REERs or, in a few cases, other REER indices (such as those adjusted for relative normalized unit labor costs). In a subset of these cases, the staff also attempt to establish how much, if any, the currency concerned is misaligned. In general, assessment is made in terms of a trade-weighted effective exchange rate. Only in rare cases is the level assessed in terms of a bilateral exchange rate against the U.S. dollar, the euro, or some other major currency.²⁶ With some notable exceptions,²⁷ country documents generally do not explain the causes of the misalignment when identified.

47. IMF staff, in using equilibrium exchange rate models, has selected a wide range of long-term economic fundamentals to determine the equilibrium exchange rate, often reflecting its understanding of the country-specific conditions. Among others, the following three factors have most frequently been selected in the construction of equilibrium exchange rate models.

• The Balassa-Samuelson effect, which has been found relevant in explaining exchange rate behavior in emerging market economies that are growing faster than their main trading partners.²⁸ Reliable data, however, are often not available.

• The terms of trade, which are often associated with supply-side shocks. A rise in the world prices for key export commodities, for example, has been found to improve the terms of trade and in turn appreciate the currency.²⁹

• The role of wealth or access to international capital markets. Such factors have been found to influence the exchange rate, particularly in a highly indebted developing country.

In addition, the staff has selected such short-term factors as cyclical measures of monetary and fiscal policy and changes in net international reserves. Exchange rate regime and trade openness have extensively been considered as structural determinants.

48. When estimates from CGER or other macroeconomic balance applications are reported, the accompanying analysis tends to share the following characteristics:

• (1) There is only a limited discussion of fundamental factors or specific policy issues.

• (2) There is a trade-off between achieving global consistency and accounting for country-specific economic conditions.³⁰ For such countries as Canada, New Zealand, and Norway, the staff noted that failure to take account of key commodity price developments was a weakness of the CGER exercise.³¹ For Mexico, the staff noted that the macroeconomic balance approach failed to take into account the impact of several structural reforms.

• (3) Estimates are sensitive to key parameters, including trade elasticities and the saving-investment norm.³² The documents for China and Egypt, for instance, show that the results from the macroeconomic balance approach critically depend on which methodology is used to estimate the medium-term saving-investment balance.³³

49. Often the discussion of misalignment is disconnected from the empirical analysis presented in the same document. For example, the fundamental determinants used to estimate the equilibrium exchange rate may not form part of the discussion on misalignment. Several factors seem to contribute to this outcome:

• The exchange rate assessment is focused on identifying the degree of any misalignment.

• Data limitations and the resulting lack of confidence in the estimates obtained mean that any identified misalignment is therefore subject to considerable uncertainty.

• As noted before, the choice of some models (such as the CGER methodology) is not amenable to country-specific policy analysis.

As a result, the reported estimates serve only as a point of reference for policy discussions.