The IMF’s core mission is to promote economic stability around the world. It does so by overseeing the global economy and the economic and financial policies of its 185 member countries. This activity is known as surveillance. And central to surveillance is the IMF’s analysis of its member countries’ exchange rates. But how does the IMF’s work on exchange rates actually benefit individual countries and the global economy?
In an interview with the IMF Survey’s Archana Kumar, two IMF experts—Jonathan Ostry (Deputy Director, Research Department) and Gian Maria Milesi-Ferretti (Chief of the Exchange Rate Issues Division, Research Department)—answer a range of questions about the IMF’s work and thinking on exchange rates.
IMF Survey: Exactly what work does the IMF do on exchange rates?
Ostry: Under the Articles of Agreement, a key responsibility of the IMF and its members is to “assure orderly exchange rate arrangements and promote a stable system of exchange rates.” In simple terms, this means a system that facilitates the exchange of goods, services, and capital among countries; that sustains sound economic growth with reasonable price stability; and that fosters economic and financial stability. Discussions on exchange rate issues (or what we call “exchange rate surveillance”) have therefore always been a central part of the dialogue between member countries and the IMF. Of course the world has changed a lot—think of the collapse of the Bretton Woods system of fixed exchange rates—and the IMF has adapted and strengthened its framework for analyzing exchange rates accordingly.
Also, as part of its Consultative Group on Exchange Rate Issues, or CGER, the IMF makes analytical assessments on whether an exchange rate is overvalued, undervalued, or broadly in line with economic fundamentals. These judgments have been an important part of our exchange rate work since the mid-1990s.
IMF Survey: And why does that work matter—why is it important?
Ostry: The objective of surveillance is to generate the information that can allow us to have a sensible discussion with country authorities about their policies. The aim is to forewarn of emerging problems, so as to avert a messier denouement. Let me give you an example. Departures from medium-run exchange rate equilibrium may reflect a number of factors. They can be the result of distortionary or unsustainable policies and create distorted incentives for the private sector; they can forewarn of an eventual return to equilibrium—for example, a large depreciation—that might have adverse domestic or external effects; or they may instead be part of an adjustment process that is already understood and internalized by markets and may thus pose no policy concerns at all. Exchange rate surveillance needs to figure out through a process of analysis and dialogue which of these stories is most likely to be true.
IMF Survey: Has the IMF’s thinking and work on exchange rates evolved as the world has become increasingly globalized?
Milesi-Ferretti: Indeed, yes. The role of exchange rates has become more important as globalization has taken off. During the past 15 years, international trade and financial integration have grown very rapidly. Economies have become more tightly interwoven and developments in one economy have larger repercussions beyond its borders. Movements in exchange rates—which are the relative price of goods and financial assets in one country relative to those in another—are clearly the prime channel of transmission of shocks among different economies. Emerging market countries, which now contribute far more to world GDP, have been prime drivers of this process. These developments made it essential to adapt the IMF’s “global” approach to assessing the consistency of exchange rates with medium-term fundamentals.
IMF Survey: Is the IMF’s evolving approach to analyzing and assessing exchange rates serving its membership?
Ostr y: We have learned a lot from our interactions with members of the IMF’s Executive Board, and also from our outreach efforts. The feedback we have received is that the frameworks developed by the CGER can play a role, but that they need to be supplemented by country-specific analysis. This is important because CGER cannot encompass every single factor that matters for a specific country’s exchange rate. So the CGER work is a building block, but not the end of the story.
In terms of our current priorities, we have developed a self-assessment tool to gauge the extent to which CGER assessments help to predict the direction of subsequent movements in real exchange rates. Our initial results are encouraging, in the sense that the CGER assessments appear to predict subsequent exchange rate movements over the medium term. We are also developing methodologies to assess exchange rates and external balances in exporters of exhaustible natural resources, which are currently not included in the CGER exercise. This is a particularly topical issue, given the run-up in commodity prices.
IMF Survey: Where would you say the IMF’s comparative advantage lies in its work on exchange rates?
Milesi-Ferretti: I would say that there are two sources of comparative advantage. First, in its work on a specific country’s exchange rate level and exchange rate regime choice, the IMF can draw not only on its expertise on the country, but also on a wealth of cross-country experiences. The crosscountry perspective can provide very useful insights on the most appropriate advice the IMF can give to the country.
Second, the IMF analysis of exchange rates relies on a multilateral perspective. This perspective takes into account not only the country’s exchange rate, but the whole constellation of exchange rates in the world economy. This multilateral perspective is essential for the Fund’s mandate to “assure orderly exchange rate arrangements and promote a stable system of exchange rates” that Jonathan referred to earlier. But it is also essential to reach an informed assessment on a country’s exchange rate level and external stability. Why? Because such an assessment has to take into account how the country’s situation and policy choices affect the world economy as well as how the country itself can be affected by developments outside its borders. The multilateral perspective is also what CGER brings to the table relative to the analysis of developments in individual countries.
IMF Survey: How do you determine if a currency is “significantly” misaligned?
Ostry: Determining whether a currency is misaligned takes into account not only the estimates from the CGER and other country-specific methodologies, but also a more general assessment of whether the level of the country’s exchange rate and the accompanying policies are a potential threat to external stability. In a nutshell, external instability represents the risk of sudden and disruptive movements in capital flows and/or exchange rates. Such movements can have negative macroeconomic consequences either for the country itself or for its trading partners.
IMF Survey: The world has been under serious economic and financial stress for over a year now. Generally speaking, how has the financial crisis affected movements in exchange rates?
Milesi-Ferretti: The financial crisis initially undermined confidence in securities backed by U.S. subprime mortgage assets, which were held by U.S. banks and foreign investors alike. The Federal Reserve responded quickly by cutting U.S. short-term interest rates. But lower returns on U.S. safe assets and the big drop in demand for asset-backed securities reduced the attractiveness of the U.S. dollar to foreign investors, causing the dollar to tumble to multiyear lows.
Also, the crisis led to an overall reassessment of risk in financial markets. This implied a weakening of currencies of countries running large current account deficits and offering higher interest rates. It also led to an unwinding of the so-called “carry trades.” Carry trades involve borrowing in low-interest-rate currencies, such as the yen, to invest in high-interest-rate currencies, such as the New Zealand dollar.
In more recent weeks, signs of an economic slowdown have spread to other countries outside the United States, including the euro area and especially the United Kingdom—a country that had experienced very sharp increases in house prices. The reassessment of the global macroeconomic environment, and the changes in expectations about the future path of interest rates, have led to a sharp decline in the pound sterling, as well as a strengthening of the dollar vis-à-vis the euro.
IMF Survey: The recent financial crisis has also shown us in a rather stark way how one country’s economic policies can affect many other countries. Does the IMF’s work on exchange rates take into account this cross-country perspective?
Ostry: It does. First, the IMF focuses primarily on so-called “multilateral” or effective real exchange rates—that is, measures that take into account not only the exchange rate and relative inflation vis-à-vis a single country (think of the euro-dollar rate), but instead vis-à-vis all main trading partners. Likewise, our work to identify equilibrium real exchange rates is focused on the effects of movements in underlying fundamentals—factors such as productivity growth or demographic trends—not only in the country itself, but relative to the rest of the world—again bringing in the cross-country context.
Second, IMF exchange rate analysis has to ensure “multilateral consistency.” In simple terms, if one or more major currencies are considered to be “undervalued,” then it must be the case that a number of other currencies is “overvalued.” Overvaluations and undervaluations need to balance each other out in the aggregate. Again, a consistent cross-country perspective is an essential underpinning of our analysis.
Third, and more generally, IMF exchange rate analysis is part of the institution’s multilateral surveillance. When assessing developments in individual countries, particularly systemically important ones, the impact on the world economy is front and center. An example of a practical application of the IMF’s multilateral surveillance activities was the Multilateral Consultation on global imbalances, undertaken with China, the euro area, Japan, Saudi Arabia, and the United States. The consultation promoted policies that, while in each country’s best interest, would also help to sustain growth and reduce imbalances in the global economy.