The current international monetary system is one in which countries have exercised the considerable freedom of choice available to them with respect to exchange rate arrangements, against the background of a large and increasingly integrated global capital market. The three largest industrial countries have opted for a managed floating exchange rate regime. Apparently, they have come to the view that whatever the potential advantages of official actions to reduce exchange rate fluctuations, the costs associated with reduced monetary policy independence are sufficiently heavy to stop them from establishing a regime whereby they would be committed to keeping exchange rates within relatively narrow, announced ranges. When exchange rate misalignments are judged to be large, these countries have temporarily elevated exchange rate objectives over the domestic requirements of monetary policy—but such circumstances have been the exception rather than the rule.
It needs to be recognized, of course, that the behavior of each of the currencies of the three largest countries is not a matter of indifference for the other industrial countries, the developing countries, or the economies in transition. Fluctuations in the exchange rates of the former, as with other key macroeconomic variables, such as output and interest rates, have spillover effects on the rest of the IMF membership. It is therefore particularly important that these external repercussions be given explicit attention in the IMF surveillance described below. Helping to ensure that the economic fundamentals are sound in the three largest industrial countries will make a major contribution to improved economic performance in the world economy and thereby to exchange rate stability.
Quite legitimately, however, some other countries take a different view with regard to their own exchange rate arrangements. The implications of high exchange rate variability for their ongoing integration efforts, as well as the expected symmetry of shocks and the benefits of using the exchange rate as a nominal anchor, are seen as sufficient to motivate more ambitious forms of exchange rate management. Members of the ERM and many developing countries are good cases in point, although the problems experienced by the ERM in 1992–93 illustrate the difficult policy requirements needed to maintain such arrangements. There appears to be no compelling reason why such differences in views across countries about optimal exchange arrangements should not continue to coexist.
Given these considerations, it appears likely that changes in the international monetary system will be evolutionary rather than revolutionary. However, this need not mean that there is little scope for improvement in the functioning of the system. After the bitter experience with inflation in the 1970s and the costs of disinflation in the 1980s, the major industrial countries seem to have learned (or relearned) the importance of assuring that monetary policy is appropriately directed toward maintaining reasonable price stability in the medium term. This is reflected in the recent convergence of inflation rates in virtually all of the industrial countries to the lowest levels in three decades—and in these countries’ apparent determination to preserve this key accomplishment. Recent progress has also been made in reducing fiscal imbalances and in beginning to put the ratios of public debt to GDP on a clearly downward course, although progress in these areas has been less pervasive than in the widespread reduction in inflation.
On the structural impediments to noninflationary growth, a good deal has been accomplished in liberalizing financial markets—as noted above—and in reforming the international trading system, but much remains to be done in the area of labor markets. Nevertheless, it is encouraging that improving the functioning of labor markets is increasingly being recognized as the key to reducing high levels of structural unemployment. Thus, on balance, the policy fundamentals for the convergence of the industrial countries to sustainable paths of noninflationary growth appear to be improving. This convergence in turn may be expected to remove one of the important sources of the volatility and misalignment of key exchange rates.
Moreover, following the large overvaluation of the dollar in the mid-1980s and the clear recognition of the costs associated with it, the major industrial countries have shown their resolve to resist a repetition of such problems—whether caused by deficient policies or by market excesses. The success of efforts at policy coordination is hard to judge and is open to some question with regard to the reduction of shorter-term exchange rate volatility; however, there is broad agreement that wide divergences of exchange rates from values plausibly implied by economic fundamentals cannot be treated with complete policy indifference. By itself, sterilized official intervention in foreign exchange markets is understood to be a tool of only limited effectiveness. It can sometimes be used successfully in a supporting role to send signals to the market, particularly to correct misconceptions about the views and intentions of policy authorities. When inappropriate policies appear to be contributing to exchange rate misalignments, peer pressure exerted through international coordination may help to move national policies in the right direction. When market forces seem to be driving exchange rates far from economic fundamentals, a united show of force by the authorities—encompassing both intervention and some policy adjustments—may be useful in counteracting bandwagon effects and other market excesses.
For the authorities of the three largest industrial countries, the key monetary and fiscal policy tools are generally perceived to have domestic objectives that are too important to allow the diversion of these policies primarily to efforts to defend relatively narrow exchange rate ranges. For these countries, sacrificing domestic economic stability to pursue a narrow concept of exchange rate stability would probably be harmful from a worldwide, as well as from a domestic, economic perspective. Accordingly, fundamental reform of the present international monetary system by transforming it into a system of target zones for the exchange rates of the major currencies is neither feasible nor desirable.
Realistically, reform of the international monetary system would better serve the fundamental purposes of the system by seeking continued improvement in the basic economic policies that create an environment for high, sustainable rates of noninflationary growth. The policy authorities of the largest industrial countries need first and foremost to keep their own houses in order. By avoiding disruptive cycles of inflation and disinflation, by achieving and maintaining sustainable fiscal positions, and by pursuing appropriate structural reforms, the governments of the largest countries will contribute not only to the growth and stability of their own economies but also to that of the entire world. International coordination that deals broadly with macroeconomic policy issues (rather than focusing narrowly on exchange rates) can contribute to this effort to secure and sustain better policies. The special contribution of such coordination should be to emphasize the international implications and interactions of domestic policies and to direct attention and peer pressure against policies that are inappropriate from both a domestic and international perspective.
Better policies should contribute in turn to greater stability in financial markets, including foreign exchange markets. Conversely, instabilities in financial markets often convey information that is relevant for economic policies. While foreign exchange markets are not unique in this regard, movements in exchange rates among the major currencies can be an important signal of either policy inadequacies or apparent departures of market forces from underlying economic fundamentals. In these circumstances, exchange rates should properly be an important focus of international policy coordination, even if the objective of such coordination is not generally to confine the exchange rates of the major independent currencies to narrowly prescribed ranges. By promoting better policies in the largest industrial countries and better international coordination of these policies—including an appropriate focus on exchange rates—it should be possible to achieve a more stable international monetary system that more effectively facilitates the growth of world trade, production, and welfare.
Under Article IV, Section 3(a) of its Articles of Agreement, the IMF is identified as the central institution with responsibility to “…oversee the international monetary system in order to ensure its effective operation….” Accordingly, the IMF has a significant role to play in efforts to improve the functioning of that system. In particular, through its exercise of surveillance, the IMF seeks to collaborate with its members in their efforts to pursue economic and financial policies that, as stated in Article IV, Section 1, support “…orderly economic growth with reasonable price stability…” and that “… promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions.” Thus, the essential objective of IMF surveillance is the improvement of the international monetary system through better economic policies (especially in the largest countries) and better international coordination of these policies. Improved analysis of economic policies and performance, more timely diagnosis of problems as they begin to emerge, and more persuasive advice on how to avoid or correct such problems can contribute to the effectiveness of surveillance.
As indicated in Article IV, Section 3(b) of the Articles, the IMF has a special responsibility to exercise “firm surveillance” over the exchange rate policies of its members within its overall mandate for surveillance. From the perspective of improving the functioning of the international monetary system, probably the most important task of the IMF in this special area of responsibility is identifying potentially serious exchange rate misalignments at a relatively early stage, together with recommending corrective measures that might help to avoid more costly resolutions of such misalignments through market forces. In the case of pegged exchange rate regimes, identifying misalignments generally means recognizing situations in which political reluctance to change established nominal exchange rates is creating serious disequilibria in real exchange rates that are not likely to be corrected without a nominal exchange rate adjustment. This, of course, is an old problem; however, recent experience indicates that it is still a very relevant one. The solution lies in accurately diagnosing the problem and communicating (confidentially) the perhaps unpopular message that the problem exists and requires correction.
In the case of floating rate regimes, misalignments can reflect two sometimes reinforcing difficulties: inappropriate or conflicting policies, and market exuberances that push exchange rates out of line with underlying fundamentals. Surveillance that identifies and advises correction of inappropriate policies is the IMF’s proper contribution to resolving the first of these difficulties. While IMF surveillance has admittedly not always been completely effective, this should not discourage its vigorous use or renewed efforts to strengthen it, including by emphasizing the role of the Interim Committee in such strengthened surveillance. The substantial uncertainty about equilibrium levels or ranges for exchange rates makes diagnosis difficult, and remedies are not always easily at hand. Nevertheless, experience suggests that circumstances do arise in which substantial exchange rate misalignments may plausibly be identified. Again, the lack of fully effective means to prevent market-driven misalignments should not be a barrier to reasonable attempts to counteract such misalignments when they are judged to be occurring. “Perfection” in the functioning of the international monetary system is not an achievable, or even a well-defined goal, and misguided pursuit of such perfection at the expense of other critically important policy objectives would be a mistake. Enhancing the effectiveness of IMF surveillance through improved analysis and more effective cooperation with and among the membership is the key contribution that the IMF can make to the evolutionary improvement in the international monetary system.
A narrow focus on the surveillance of exchange rates would be unwise. Policies that contribute to cycles of inflation and disinflation and to unnecessarily wide swings in output and employment, especially in the largest countries, will generally be a source of disturbance to the rest of the world regardless of the nature of the exchange rate regime. Surveillance that concentrates on exchange rates as the only important indicator of maladjusted policies and as the exclusive basis for policy coordination will often miss the point and could sometimes push policies in the wrong direction. Surveillance needs to have a broad focus, covering all key economic policies and all important indicators of actual or potential economic problems—including, but not limited to, exchange rates.
With the increasing international mobility of capital and the integration of capital markets, proper surveillance must also pay serious attention to developments in world financial markets. A number of recent episodes have demonstrated the importance of international financial markets as both a transmitter of economic disturbances and an evaluator of policies. Examples include the onset of the debt crisis in the early 1980s, the stock market crash of October 1987, and the sharp upward move in long-term interest rates in early 1994. Moreover, the efficient functioning of international financial markets is itself an essential requirement for a properly functioning international monetary system. Improved accounting and disclosure standards that would provide investors and creditors with better information on the creditworthiness of borrowers would assist the efficient functioning of these markets and, accordingly, is relevant to the IMF’s general surveillance responsibilities. Even more important is the development and maintenance of adequate safeguards to contain and control potential systemic risks to the stability of international financial markets and, hence, to the stability of the international monetary system.
Finally, a key line of defense against an inappropriate transmission and magnification of economic disturbances is the availability of adequate external financing for countries that experience temporary balance of payments difficulties. The IMF continues to play an important role in this regard by making its general resources temporarily available, under adequate safeguards, in order, as noted in Article I of the Articles of Agreement, to provide its members “… with the opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.” For most IMF members, however, the initial and quantitatively most important source of external financing must be either the member’s reserves or resources available through international borrowing. The level of reserves is generally not a critical concern for members that enjoy—and can reasonably expect to continue to enjoy—unimpeded access to world capital markets. However, for those IMF members that are likely to have to rely primarily on their own resources in times of difficulty, adequacy of reserves is an important issue. Because a significant number of members still have low levels of reserves and face high costs in acquiring and holding them, a reasonable case can be made to supplement other sources of reserves through an SDR allocation.