J. MARCUS FLEMING *
Economists and financial journalists, particularly in the United States and in the United Kingdom, often write as though they believed that the general abandonment of exchange rate pegging by the major countries in favor of independent floating had solved at a single stroke the difficulties besetting the international monetary system under the par value system.
In truth, however, while some of these difficulties have been overcome or greatly attenuated by the advent of floating, others persist in aggravated form. For example, the complex of problems arising out of asymmetries in the intervention system (involving asymmetries in the adjustment process and difficulties in the management of the world reserve supply)—problems to which the recent effort at international monetary reform1 was largely addressed—has been rendered in some respects more intractable than ever. It is the contention of this paper that, if these problems are to be solved, some of the proposals for reform of the par value system may have to be resurrected and adapted to the circumstances of floating.2
Before embarking on the main theme of this paper, it may be well to consider briefly the bearing of floating exchange rates on the adjustment process as it applies to countries that are not issuers of intervention and reserve currencies.
The exchange rate between any two currencies may be said to be floating if it is not fairly narrowly pegged by market intervention on the part of one or other of the issuers of the currencies involved. A currency may be said to be floating if its value is not pegged to that of any other currency, reserve asset, or composite of currencies. Currencies, like those of countries in the European common margins agreement (the so-called European “snake”), that are pegged reciprocally and exclusively to each other but not to currencies outside the group, may be said to be floating jointly vis-à-vis outside currencies. The type of floating under discussion in this paper is not, however, “clean” or “free” floating, but “managed” floating, in which the value of the currency, though not closely pegged, is, nevertheless, influenced in one direction or another by market intervention on the part of the issuing country and/or by other policies of the country directed toward that end. At the present time all floating currencies are managed to a greater or lesser extent, though in some cases (for example, that of the U. S. dollar and that of the European “snake” currencies regarded as a group) the degree of management is very slight.
The replacement of a regime of par values by one of managed floating in this sense tends to improve the adjustment process by making it easier for a country to move its exchange rate if it wishes (or permit it to move) in such a way as to maintain medium-term equilibrium in its balance of payments since the country is not hampered by prestige-involving expectations that it will maintain fixity in the rate. It also enables a country to cope with temporary and reversible capital flows, which might otherwise endanger its control over its domestic money supply, by allowing the exchange rate to fluctuate over a relatively wide range.
On the other hand, floating puts no greater pressure than does the par value system on countries that are reluctant to make desirable adjustments, and it removes one safeguard that the par value system offered against inappropriate changes in exchange rates, brought about by the authorities of the country in question—namely, the necessity of obtaining Fund concurrence in any devaluation or revaluation. Moreover, there is a possibility that floating exchange rates—even, and perhaps especially, if they are allowed to vary freely in response to market forces—may fluctuate to an extent that is unduly damaging to stability in the foreign trade industries and possibly also unduly inflationary in its net effect on prices.
It is with these weaknesses in the regime of floating rates that the Guidelines for the Management of Floating Exchange Rates, recently adopted by the Fund,3 are intended to deal. These guidelines are reproduced, for convenience of reference, in the Appendix to this paper.
The intention of Guideline (2), in conjunction with Guideline (3) (a), is to prevent countries from actively moving their exchange rate—as distinct from resisting market tendencies—except in the direction of the medium-term norm. The intent of Guideline (3)(b) is to encourage countries to yield to market pressures that tend to move the rate in the direction of the norm and to resist tendencies that cause the rate to diverge unduly from it. The intention of Guideline (4) is to urge countries to take account in their intervention policies of the level of their reserves, so as to discourage undue reserve accumulation or reduction.
These guidelines, taken together, should help to prevent competitive depreciation or appreciation and to promote—though they do not ensure—appropriate adjustment of exchange rates. Guideline (3)(b) should also do something to prevent excessive swings in rates. Appropriate exchange adjustment can be further promoted, under floating rates as under par values, by rules prohibiting the use of measures that tend to bring about maladjustment or inappropriate types of adjustment. An example of this is provided by Guideline (5), which is directed against the use of restrictions on current transactions or payments.
Some of the principal problems of the par value system as it existed up to 1971 arose out of the degree of asymmetry with which it operated between the issuer of the principal reserve and intervention currency and other countries. On the one hand, the United States was hampered in dealing with short-term and cyclical fluctuations in its balance of payments by the fact that the potential range of fluctuation of the dollar around parity vis-à-vis other currencies was only half the range open to other countries. It was also hampered in adjusting to fundamental disequilibrium by the likelihood that, even if it were to suspend convertibility, intervention by other countries would limit the freedom of the dollar to float in search of a new and viable parity. On the other hand, as a by-product of the intervention system even under convertibility, U. S. deficits tended to be financed in large part through an accumulation of official dollar claims, and this relieved the United States of the pressure, to which any other country would have been subjected, to devalue its currency, or otherwise adjust, when in balance of payments deficit. Moreover, to an extent that is a matter of dispute, the role of the U. S. dollar as the central intervention and reserve currency may have made it more difficult for the United States to change its par value without provoking corresponding changes by other countries.
Finally, the asymmetrical character of the intervention system, taken in conjunction with the system of currency convertibility at the discretion of the holder, made the supply of foreign exchange reserves in the world a function of the payments imbalance of the principal reserve center and may have made it more difficult to attain the objective for which the Special Drawing Account of the Fund had been set up (that of achieving a rational control over the world’s reserve supply). However, the main responsibility for this lay with the practice of holding foreign exchange in reserves as such and with the irregularity of conversion and settlement arrangements; if asymmetry made matters worse, it was probably through its tendency to accentuate the payments imbalances of reserve centers.
A very large part of the effort from 1972 onward to reform the international monetary system was devoted to this complex of problems. Two main solutions were advanced, but the reform effort ended without agreement on these:4
(1) The adoption by the principal countries of a multicurrency intervention system under which the U. S. dollar would have the same margin of fluctuation as other currencies, and from which, if the United States were forced to suspend convertibility, the U. S. dollar, like other currencies, would be free to float without being hampered by intervention on the part of countries other than the issuer;
(2) The adoption of a system of settlement under which reserve centers like other countries, would settle deficits and surpluses in the main through variations in their reserve asset holdings and not through variations in their liabilities, thus preventing unplanned variations in the aggregate supply of foreign exchange reserves.
In addition, it was suggested that a substitution facility should be created in the Fund, from which countries could obtain newly created SDRs in exchange for foreign currency, and to which reserve centers could in certain circumstances sell and from which they could redeem their own liabilities against SDRs. (This was advocated as essential to the implementation of these solutions.)
The question arises whether problems of asymmetry and reserve control persist under conditions of generalized floating and, if so, whether they can be solved without resort to devices analogous to those described above.
As floating has spread, there has been little, if any, decline in the asymmetry of intervention arrangements in the world. The abandonment of convertibility by the United States, which signaled a desire that the dollar should float and stimulated floating by other countries, at first strengthened multicurrency intervention in Europe, but the victories of independent floating in 1972 and 1973 involved the abandonment of these arrangements by one participant after another and led to a recrudescence of dollar intervention by the floating countries. Although some of the countries customarily pegging their currencies to the U. S. dollar may have been induced by the events of 1971–74 to diversify their reserves and intervention practices, this effect has been offset by a shift into dollars on the part of sterling area countries.
This persistent asymmetry is likely to be at least as damaging to the exchange rate autonomy of the United States under floating rates as it was under par values. Admittedly, the fact that the issuers of the other main currencies do not in practice intervene as promptly to limit fluctuations in their own dollar exchange rates as they would have done under par values gives somewhat greater freedom for the dollar to move in the direction indicated by market forces. However, it is no longer possible, as it was under the par value system, for the United States to achieve a change in its effective exchange rates by formal devaluation. Moreover, the value of the dollar is much more responsive than under that system to the balance of purchases and sales of dollars by other monetary authorities undertaken in the light of their own situations. Thus, if countries that peg closely to the dollar happen to have deficits (surpluses) while other countries allow their currencies to float more freely, the value of the dollar may fall (rise) for reasons that have nothing to do with the U. S. balance of payments as such. Again, if important countries, for reasons of anti-inflationary policy, welcome the appreciation of their currencies, the dollar may be allowed to decline too much in the market. But if changing domestic conditions in these countries should make competitive depreciation appear advantageous, the dollar might be forced into an overvalued position very much more quickly and easily than would have been the case under par values.
It is possible, however, to exaggerate the problems arising out of this asymmetry. In the first place, these problems arise only to the extent that countries seek to influence their exchange rates through market intervention. If a country intervenes on the exchange market in order to raise or lower the value of its currency, it may alter the value of the intervention currency vis-à-vis third currencies, whereas if it uses a capital-flow-deflecting policy (such as monetary policy or capital restrictions) for the same purpose the effect is diffused over a much wider range of currencies and the value of the intervention currency vis-à-vis third currencies need not be affected. Moreover, the United States itself can use such policies to influence the value of the dollar.
Guidelines for floating may also help to mitigate the effects of asymmetry of intervention. As a general rule, the more that other countries conform to the guidelines in conducting their intervention policies, the more appropriate the movements in the value of the currencies of intervention will tend to be. Indeed, if only one intervention currency existed, and if the effective exchange rates of all the other currencies were appropriately adjusted to consistent balance of payments targets, the effective rate of the single intervention currency would likewise be entirely appropriate.
From some points of view, the fact that the U. S. dollar—the principal intervention currency—is no longer officially convertible into primary reserve assets may be regarded as yet another factor making asymmetry more tolerable. Dollar inconvertibility may somewhat reduce the temptation for other countries to buy dollars in intervention and thus bid up its value. And even when it does not have this effect and the dollar experiences some overvaluation, at least the United States does not suffer a loss of reserves. On the other hand, as will be seen later, this very inconvertibility may have unfortunate consequences for the world supply of reserves.
Three ways of dealing with the problem of asymmetry are considered below: unilateral intervention by the reserve center; bilateral agreements on intervention; and multilateral regulation of the choice of intervention currencies.
Intervention by the United States
Thus far, it has been assumed, as an expository device, that the United States, as issuer of the main intervention currency, would not itself intervene on exchange markets. But, of course, the United States is as much entitled to intervene as any other country, and indeed has done so. Such intervention, however—unlike that of the issuers of secondary intervention currencies, such as the United Kingdom and France, which intervene on a substantial scale in dollars—has thus far been on a relatively small scale. Moreover, it has been of a very short term and—insofar as it has been conducted with currencies obtained under swap arrangements—of a quickly reversible character. U. S. intervention, to a much greater extent than that of subsidiary reserve centers, has been of a bilaterally coordinated type, but in this section we shall consider the possibilities (and difficulties) of unilateral intervention.
Intervention by the issuer of intervention currencies is subject, like that of other countries, to the guidelines for floating. In this connection a preliminary question of definition arises: whether intervention should be measured in terms of the movement of gross or of net reserves.
The case for Guideline (2) rests on the theory that intervention should neither exaggerate nor thwart the influence of market forces on the rate of exchange. If variations in official holdings of foreign currencies are regarded as outside the concept of market forces—and, indeed, as primarily compensatory to such forces—there is a logical case for defining intervention by a country in terms of the change in its reserves net of liabilities to foreign monetary authorities. In that case, it would be compatible with Guideline (2) for the United States to acquire gross reserves (for dollars) even when the dollar was falling in value, if other countries were simultaneously buying dollars in larger amounts, or for the United States to use reserves to buy dollars even when the dollar was rising, if other countries were selling dollars in larger amounts. However, this process would have the disadvantage that, in order to comply with Guideline (2), when the dollar was falling, the United States would have to buy at least as many dollars as other countries were selling, and when the dollar was rising, it would have to sell at least as many dollars as other countries were buying. Since it would clearly be burdensome on the United States to be obliged to offset the dollar interventions of other countries, it would seem preferable to define intervention for reserve centers as for other countries, in terms of gross reserve changes adjusted for compensatory official transactions—thus treating movements of other countries’ holdings of a country’s currency, other than those attributable to official borrowing, as analogous, from the standpoint of the latter country, to movements of private capital.
Even with this definition of intervention, it is still possible for the United States, conformably with Guidelines (2) and (3), to resist, to a greater or lesser extent, movements in the dollar’s effective rate, including movements that result from the intervention of other countries, particularly if these are carrying the rate away from any reasonable estimate of the medium-term norm. In that event it would also be free to overcompensate market tendencies and the effects of intervention by others by action that brings the rate closer to the norm.
There are, however, considerable difficulties in large-scale intervention by the United States, some of which apply to intervention by subsidiary reserve centers, while some do not.
(1) Insofar as reserve centers tend to buy (sell) other currencies in intervention when their own currencies are bought (sold) in intervention, variations will take place in the supply of reserves. This problem, which concerns intervention by all reserve centers, large or small, will be considered in a later section.
(2) While subsidiary reserve centers, such as the United Kingdom, for the most part conduct their intervention in dollars, for which a very broad exchange market exists, the United States, if it has to intervene, must do so in currencies for which the market is much narrower, so that any U. S. intervention would be likely to have a greater effect on the value of the currency used than on that of the dollar, relative to currencies in general. This means, at least, that any substantial U. S. intervention, unless it happens to be in a direction welcome to the issuer of the currency used, would have to be divided among a number of currencies. Even if this were done, the countries affected might not welcome such an intervention whenever it appeared desirable to the United States from the standpoint of dollar management, especially as some of these countries are not accustomed to having their currencies used for intervention purposes.
(3) While subsidiary reserve centers intervene in currencies other than those of the countries that normally intervene in their currencies, the United States would have to intervene in the currencies of countries accustomed to intervene in dollars. Such mutual intervention, unless somehow regulated, is likely to give rise to frictions. Even in the most favorable conditions, when both parties wish to intervene in the same direction—that is, both wish to buy dollars for the other currency or to buy the other currency for dollars—differences of opinion might arise as to how large the total intervention should be or as to how it should be shared between the countries. Much more unfortunate would be a situation in which the two parties intervened at cross purposes, in a mutually offsetting way. This situation could occur without malice on the part of either country if both the United States and the other country considered its own currency to be undervalued or overvalued, as the case might be, if the other country regularly intervened in the dollar, and if the United States had no criterion but convenience of choice of its currencies for counterintervention. Even so, there would clearly be a danger that disputes would arise.
One approach to the solution of these problems is to require that intervening countries arrive at agreements with the issuers of intervention currencies regarding the use of these currencies in intervention. The Ministers of the Group of Ten came close to adopting this approach in their meeting of March 16, 1973, at which each nation stated that it would be prepared to intervene at its own initiative in its own market in close consultation with the countries whose currencies were being traded. The United States appears to have followed this practice in the fairly moderate interventions which it has undertaken from time to time. Guideline (6) goes a little further by suggesting, though not prescribing, that mutually satisfactory arrangements be agreed between the issuers and users of intervention currencies with respect to the use of such currencies in intervention.
The problem is, however, how such arrangements are to be made mutually satisfactory. In particular, how can customary reserve centers be protected against interventions that lead to undesirable movements in their rates without depriving customary users of their currency of the ability to stabilize their own rates, when issuers of other currencies either do not wish them to be used or wish to be in a position to control each use? Guideline (6) says that such arrangements should be compatible with the purposes of the other guidelines. This protects the right of customary users of the main intervention currencies but might not do much to protect the interests of the reserve centers even if the latter were to seek to act as judges and enforcers of the observance of Guidelines (1) to (4) by other countries, an attitude bound to lead to disputes.
All intervenors are adjured in Guideline (6) to bear in mind the interests of the countries issuing reserve currencies—interests which, in the commentary to the guidelines, are stated to include their need for reasonable freedom of exchange rate movement. The question is how the intervenors are to do this without impairing their rights of intervention in circumstances in which countries other than reserve centers are reluctant to allow their own currencies to be used for this purpose. A system in which all countries had the right to control the use of their currencies in intervention, and exercised that right with respect to each use, would clearly be unduly restrictive of desirable intervention.
Guideline (6) envisages that the Fund would assist in resolving disputes in connection with arrangements between users and issuers of intervention currencies, and the commentary suggests that such disputes may arise with respect to intervention in noncustomary reserve currencies, interventions that move the value of an intervention currency in an undesirable direction, and mutually offsetting interventions. This comment represents an implicit acknowledgment that such difficulties and problems are unlikely to be entirely resolved on the basis of purely bilateral arrangements without the working out of more general principles to which such arrangements would conform.
Guidelines for the choice of intervention currencies
At this moment there is neither an accepted doctrine governing the choice of currencies to be bought and sold in intervention nor a mechanism for making that choice effective. In Annex 4 of the Outline of Reform,5 which was based on the assumption that par values would be the rule and floating the exception, it was proposed (a) that a floating country should normally buy the “weakest” and sell the “strongest” of the currencies among which it had an effective choice, and (b) that other countries should not normally intervene in a floating currency without the agreement of the issuer.5 As regards “effective choice,” there is some ambiguity in the Outline as to the extent to which countries other than members of a multicurrency intervention system would be entitled to choose, among nonfloating currencies, their preferred intervention currency; they must consult the issuer about this choice, but they are entitled to have appropriate intervention facilities made available to them.6 Since intervention would normally be carried out in currencies with a par value, there is no ambiguity as to what is meant by the “strongest” and by the “weakest” of the available currencies—strength and weakness would be measured by the position of market rates relative to parities. Since it is assumed that many countries whose currencies could serve as intervention currencies would be observing par values, countries whose currencies happened to be currently floating would be entitled to deny the use of their currencies for this purpose, except possibly to countries that “regularly” intervene in their currencies, in which case some suitable arrangement should be worked out.7
When all the principal currencies are floating, the provision of the Outline according to which floating currencies can be used only for intervention with the consent of the issuer cannot apply without qualification; as already noted, Guideline (6) does not attempt so to apply it. It would seem desirable in these circumstances to establish under Guideline (6) a set of arrangements that would enable each country to intervene in a variety of currencies, provided that in choosing the currency to use on each occasion the country would follow some generally accepted principles or rules. Is it possible to devise a system governing the appropriate choice of intervention currencies that would be applicable in such circumstances? Prima facie, the principle governing such choice of currencies should be that of reinforcing the action that the issuers of the currencies should themselves be taking under the guidelines. The elaboration of this principle, however, is not without difficulties. Guidelines (2) to (4) attempt to blend in a particular way three separate criteria: the “moderation” criterion of Guideline (2), the “normal rate” criterion of Guideline (3), and the “normal reserve” criterion of Guideline (4). In certain circumstances, as described in Guideline (4), the moderating intervention of Guideline (2), modified by the reserve criterion, is supposed to operate; in other circumstances, the normal rate criterion of Guideline (3), again modified by the reserve criterion, takes over.
Now, it is difficult to conceive of choosing intervention currencies on the basis of Guideline (2), even as modified by Guideline (4). This would require the intervening country to buy on the market currencies whose market value was falling (unless their issuers had abnormally low reserves) and to sell on the market currencies whose market value was rising (unless their issuers had abnormally high reserves). Moderating intervention (“leaning against the wind”) may be a costly business, and countries can hardly be expected to share in the cost of moderating the movements in other countries’ currencies, as they would presumably have to do in the absence of immediate asset settlement (see below). Any system governing the choice of intervention currencies would therefore probably be based on the normal rate principle of Guideline (3) as modified by reserve considerations of Guideline (4). In other words, intervening countries would be permitted and encouraged to buy, in exchange for their own, currencies that were considered to be undervalued and to sell those considered to be overvalued relative to their medium-term norms.8
Even this criterion raises problems of implementation, only some of which can be mentioned here. There is a general resemblance between the overvaluation/undervaluation criterion offered here and the strong currency/weak currency criterion suggested in the Outline and referred to above. In the Outline, where the assumption is that intervention currencies are observing par values, it is understood that the “strength” or “weakness” of a currency relates to its market value relative to parity—a rather precisely defined concept. Here, however, where the intervention currencies are assumed to be floating, overvaluation or undervaluation relates to the much vaguer concept of market value relative to a “normal zone,” the width of which may vary from country to country and which may not be universally recognized as such. There is the question of who is to be the judge of overvaluation and undervaluation: the issuing country, the intervening country, or the Fund; and the question of how such judgments would be arrived at. It would clearly simplify matters if countries generally followed the procedure of Guideline (3)(a) and agreed at all times with the Fund on a target or normal zone for their effective exchange rates. Failing this, any such judgments would have to be implicit in any guidance that might be given by the Fund, under Guideline (6) or otherwise, as to which currencies would be appropriate to use for intervention.
Apart from the problem of identifying the most overvalued and the most undervalued currencies, there is the problem of ensuring that the amount of intervention that takes place in particular currencies is adapted to the capacity of the market and does not lead to excessive rate movements. This requires that the flow of net intervention should be proportioned to the capacities of different markets and that large interventions by particular countries should be divided among different currencies. For the Fund to carry out successfully the function of guiding the countries’ choices of intervention currencies would require that it maintain close consultation with the issuers of the currencies to be recommended for use. Issuing countries might sometimes desire that their currencies be bought or sold in intervention, thus supporting or depressing their exchange rates, without wishing to intervene themselves, and their wishes could be taken into account by the Fund in its recommendations to intervening countries.
Thus far, it has been assumed that a country can always obtain the currency or currencies appropriate for it to sell on the market when it wishes to support its own currency. But, of course, a country in this position may not currently possess the currency it is supposed to sell, and the problem then is how to obtain this currency. If the country were to buy it on the market by selling, say, a currency held in its reserves, it would, in effect, be bringing downward pressure on the market value of the reserve currency, and not on that of the appropriate intervention currency. What is required is some technique whereby supplies of appropriate intervention currencies can be obtained otherwise than through the market. One way might be through the use of swaps which are subsequently settled in primary reserve assets (gold or SDRs); another might be through direct purchase with primary reserve assets. But there is at present no obligation on countries to provide currency in exchange for gold (even at market price), and while countries are obliged to accept SDRs in designation, they are free to provide any currency convertible in fact and are not obliged to provide the particular currency required for intervention, even if it should be their own currency. Moreover, the criteria presently used in designating countries to receive SDRs pay no regard to the overvaluation or undervaluation of their currencies. There might, therefore, be a need for a new or additional system of designation geared to the needs of the intervention problem, operating under rules that differ from those set forth in Article XXV, Section 5(6) and Schedule F.9
A system of guided intervention of the type described above would require countries to be willing to acquire in intervention reserve currencies which are unfamiliar and of which it is uncertain whether they can appropriately be sold when the time comes for the country to support its own currency. Again, in order that countries may be able to sell the appropriate currencies in intervention, it is necessary that they possess or have access to a sufficient supply of primary reserve assets to enable them to obtain these currencies through designation. For both of these reasons it would probably be necessary to the success of the system that any currencies that countries hold or acquire should be convertible into SDRs. In order to avoid undue pressure on the reserves of traditional reserve centers, such conversion would have to be carried out by, or with the aid of, a substitution account of the type mentioned in paragraph 22 and described in Annex 7 of the Outline of Reform.10 Such an account would have to be prepared to acquire, in exchange for SDRs created for the purpose, not only traditional reserve currencies but also other currencies used in intervention. The problems which convertibility raises for the issuing countries are considered more fully in the following section.
The system of guidance described here has the advantage over untrammeled intervention by the reserve center of avoiding any danger of countries intervening at cross purposes in each other’s currencies. It has the advantage over intervention under bilateral agreement of ensuring that countries are not frustrated in their desire to stabilize their own exchange rates. And it probably has the advantage over both of these alternatives in the extent to which it achieves the purposes of the guidelines for floating exchange rates. It does, however, have some tendency to increase the amount of stabilizing intervention that takes place in any currency beyond what the issuer might have desired; those who wish to intervene can always do so, but those who do not wish their currencies to be used for intervention may be unable to prevent it. It might, however, prove possible to counteract this bias to some extent through requirements to consult issuing countries and other procedural guidance.
One of the main weaknesses of the par value system as it operated in the past, with official reserves held in large part in the form of foreign exchange convertible on demand, was that it made the supply of world reserves a by-product of (a) disequilibria in the balance of payments between reserve countries and nonreserve countries, and between countries with different marginal propensities to hold foreign exchange in reserves, and (b) variations in the relative attractiveness of holding reserves in the form of foreign exchange and gold, respectively.
Under a system of managed floating without convertibility, variations in the holding of foreign exchange reserves as a result of (b) would be reduced if not completely eliminated. As regards (a), such reduction is more doubtful. If the issuers of intervention and reserve currencies themselves refrained from intervention, and if exchange rates were allowed to respond more flexibly to short-term balance of payments disequilibria than they could under the par value system, the volume of intervention by countries with independently floating currencies would probably be reduced. However, as Williamson has pointed out,11 the extent of such reduction may not be great and the volume of intervention by countries whose currencies are pegged to particular floating currencies might well increase. This has implications not only for the demand and need for reserves but also for the stability of their supply. The greater the use of reserves—presently almost exclusively a use of foreign exchange reserves—the greater are likely to be the variations in the net aggregate official purchases or sales of currency and hence in the world reserve stock. Moreover, if countries with floating currencies were to make use of their ability to intervene on the exchange market to bring about a chronic undervaluation of their currencies relative to the U. S. dollar (and this was argued above to be a potential danger), they might accumulate at least as many reserves as under a par value system.12
To the extent that competitive depreciation was reduced by the observance of guidelines for floating, the chronic accumulation of reserves in the form of foreign exchange would likewise be diminished. However, if the same result were achieved through counterintervention by the reserve centers, the gross accumulation of currency holdings might be even further increased. Moreover, temporary inequalities between the accumulation of reserve currency holdings by countries with a strong payments position and their reduction by countries with a weak one would tend to evoke a corresponding accumulation or reduction of other currencies by the reserve countries, and thus lead to magnified variations in total holdings of foreign exchange. This magnification both of chronic reserve accumulation and of reserve variation through counter-intervention could be avoided by the adoption of a system governing the choice of intervention currencies, such as has been described toward the end of the preceding section. In general, the observance of guidelines for floating, including those for the choice of intervention currencies, would minimize the amount of uncontrolled variation in the supply of reserves; however, it would not eliminate such variation.
In the reform discussions, the most effective remedy advanced for the purpose of preventing undesired variations in the supply of foreign exchange reserves and of ensuring effective management of the global reserve supply was some form of systematic and regular asset settlement, whether applied through bilateral presentation of currency accruals by the holders to the issuers for conversion or, preferably, through collective settlements between the issuers and a substitution account in the Fund.13 Under managed floating also, asset settlement remains the only device through which any precise international control over the supply of reserves could be achieved.14
It is often assumed that asset settlement and floating are mutually exclusive, but this is a mistake. While readiness on the part of the issuer of a currency to convert it into some primary reserve asset or other currency at a fixed rate of exchange might well suffice to peg the value of the former even without active intervention on the exchange market, convertibility at rates determined by the conventional value of the primary reserve asset and the market value of the currency would not, of itself, interfere with floating. It is this second type of convertibility that is in question here, and asset settlement of deficits and surpluses at market-determined rates is all that is required to prevent variations in the supply of currency reserves and to permit international control through SDR allocation over the supply of reserves.
Asset settlement calls for a regulated amount of conversion by the issuing country. Given a strict asset settlement system, it makes no difference either to the reserve position of the issuing country or to the amount, as distinct from the composition, of the reserves of other countries whether or not holders of currency reserves can convert them into primary reserves at will, even if such conversion is carried out by presentation to the issuers rather than to a substitution account. Any variations in the primary reserves of the issuer resulting from variations in the amounts converted by holding countries will be made good to the issuer through its settlements with the substitution account. In view of this, and since, as indicated above, it would facilitate the choice of appropriate intervention currencies, it would seem desirable that asset settlement should be accompanied by freedom for countries to convert their currency holdings at will.
There would be obvious difficulties about introducing asset settlement in a situation of generalized floating so long as counterintervention by issuers of reserve currencies was not regarded as normal and no effective rules governed the choice of intervention currencies. The harm done to the issuer of an intervention currency that was bid up to an overvalued level by the intervention of others would be greater and more difficult to endure if that country were not merely forced to accumulate indebtedness and possibly suffer unemployment through foreign competition but were actually drained of its reserves, thus losing its power to protect itself against a subsequent possible depreciation. Asset settlement might be less unwelcome to a reserve center that practiced counterintervention since, as it accumulated claims against other countries to balance other countries’ claims against it, the former would be canceled against the latter, thus reducing or eliminating any net loss of reserves. However, the dangers of conflict associated with the acquisition of mutual claims might be intensified if the claims so acquired had to be mutually canceled, however desirable such action might be from the standpoint of world reserve management.
The conditions under which asset settlement would be least burdensome for issuers of intervention currency would probably be those in which intervention was subject to international guidance of the type described in the preceding section. The issuers could be assured that their currencies would be bought by other countries only when they were considered to be undervalued, at which time they might themselves be contemplating intervention in support of their currencies. One should not, however, underrate the difficulties of inducing countries to accept asset settlement under conditions of floating. A country that is obliged to spend reserves to redeem its currency which other countries have bought in intervention is, in effect, being forced to intervene in support of its own currency; similarly, a country that is designated to receive SDRs in exchange for its own currency which is then sold on the market is, in effect, being forced to intervene to hold down the value of its currency. There is, of course, a natural limit to the extent to which asset settlement can be carried; if a country did not have sufficient reserves to finance the asset settlement of the deficits that would be imposed upon it if other countries purchased its currency, it would be entitled to refuse settlement—and, if it did refuse, its currency might be removed from the list of those suitable for purchase in intervention, although the currency might still be undervalued.
Granted that floating, even if managed on acceptable lines, is likely to involve substantial variation in holdings of currency reserves, which, in turn, could impede the successful control of the quantity of world reserves through SDR allocation, the question arises whether the supply of reserves resulting from the operation of the floating system would not automatically adapt itself to the need for reserves, thus making SDR allocation unnecessary. Quite a strong case can be made for this thesis.
If all countries had floating currencies, if all exercised their rights to intervene on exchange markets, and if the level of reserves was the only criterion determining the amount and direction of their intervention, then each would soon attain its desired level of reserves in the form of foreign currency. This would mean clearly that reserves were acquired either for their own sake or for the income they might yield, but in fact they are also acquired for potential use, which involves intervention for purposes other than attaining or retaining a desired level of reserves. Even under floating rates, exchange market intervention in the short to medium term is governed by considerations relating to the stability and level of exchange rates, including attitudes toward competitive undervaluation and disinflationary overvaluation. These considerations not only dominate intervention in the short run but also may impede or delay progress toward the attainment of the level or trend-path of reserves around which countries would wish their reserves to fluctuate.
Adherence to Guidelines (1) to (3), with their concern about exchange rate tendencies and levels, might impose a slight further obstacle to the rapid attainment of countries’ desired reserve targets, although Guideline (4) might actually facilitate such attainment.
A system of complete freedom in the choice of intervention currencies would probably impede the attainment of desired reserve levels since, as has been pointed out above, concern about exchange rates could lead in the short run to multiplied expansions and contractions in reserve holdings, including substantial variation in the mutual holding of balances by pairs of countries. In such a situation countries would tend to lose sight of reserve targets or become uncertain about them. A system in which the use of intervention currencies was tightly controlled by the issuing countries would tend to hamper intervention and thus the attainment of desired reserve levels in another way. Probably international guidance of the choice of intervention currency would be most favorable of all to the attainment of desired reserve levels.
After all the qualifications have been noted, it must be admitted that in a regime of generalized floating, even of a highly managed variety, the amount of reserves held would probably tend to approximate much more closely and continuously the amount that countries desired to hold than it would in a par value system. Some would conclude that this would make the reserve system more nearly self-regulating and would make the need for SDR allocations less. However, it should be borne in mind, as the author has argued in previous publications,15 that the optimal level of world reserves is not necessarily identical with the sum of the reserves demanded by countries.
Finally, lest the argument be misapplied to the present situation, it should be noted that the currencies of the great majority of countries are not floating independently but are pegged to other currencies and that the reserves of such countries are no more under their control than they were in the heyday of the par value system.
The foregoing argument has followed a somewhat meandering course with many feedbacks and interrelationships among its phases. Let us try to set it forth in broad outline. It has been argued that in a system of widespread managed floating, as in a par value system with occasional floating, there is a problem of asymmetry of adjustment between the issuers of the principal intervention currencies and other countries, as well as a problem of ensuring an effective international management of reserves. If the latter problem is less acute under a floating system, the former problem is potentially more acute than it would be under a par value system.
It is argued that under floating rates as under par values, the best solutions for these problems involve a combination of three elements: organized multicurrency intervention, asset settlement, and an SDR substitution account. A development of the system of SDR designation would also be required.
Although widespread floating would appear to offer no particular obstacle to the operation of a substitution account, its effect on the acceptability of asset settlement is debatable, and it would add considerably to the difficulties of organizing multicurrency intervention. Insofar as the arrangements for floating, including observance by other countries of the existing guidelines for the management of floating rates and the proposed guidance for the choice of intervention currencies, gave assurance to reserve centers that they were unlikely to be in payments deficit unless their currencies were genuinely undervalued, asset settlement should be easier to accept under floating than under fixed rates; but the fact that these deficits were to some extent imposed by the intervention decisions of other countries might work in the opposite direction.
The peculiar difficulty of organizing multicurrency intervention under a floating rate system arises from the absence of clear, precise, and agreed criteria as to which currencies should be bought and sold in intervention and in what quantities they should be bought and sold. Under a par value system, these criteria are supplied by the fixed margins around known exchange rate parities; under floating rates they would necessarily involve some exercise of judgment by an international body in consultation with the countries concerned.
If it is politically acceptable, a system of guided intervention oriented to an established system of normal exchange rate zones would probably be superior to any other arrangement under floating for the purpose of promoting symmetry in adjustment while permitting an adequate degree of exchange rate management and avoiding the anomaly of mutually offsetting intervention. It could be achieved, if at all, only as a result of a gradual evolution, which is unlikely to get seriously under way as long as countries nurse the hope of returning, someday, to a par value system.
(1) A member with a floating exchange rate should intervene on the foreign exchange market as necessary to prevent or moderate sharp and disruptive fluctuations from day to day and from week to week in the exchange value of its currency.
(2) Subject to (3)(b), a member with a floating rate may act, through intervention or otherwise, to moderate movements in the exchange value of its currency from month to month and quarter to quarter, and is encouraged to do so, if necessary, where factors recognized to be temporary are at work. Subject to (1) and (3)(a), the member should not normally act aggressively with respect to the exchange value of its currency (i.e., should not so act as to depress that value when it is falling, or to enhance that value when it is rising).
(3) (a) If a member with a floating rate should desire to act otherwise than in accordance with (1) and (2) above in order to bring its exchange rate within, or closer to, some target zone of rates, it should consult with the Fund about this target and its adaptation to changing circumstances. If the Fund considers the target to be within the range of reasonable estimates of the medium-term norm for the exchange rate in question, the member would be free, subject to (5), to act aggressively to move its rate towards the target zone, though within that zone (2) would continue to apply.
(b) If the exchange rate of a member with a floating rate has moved outside what the Fund considers to be the range of reasonable estimates of the medium-term norm for that exchange rate to an extent the Fund considers likely to be harmful to the interests of members, the Fund will consult with the member, and in the light of such consultation may encourage the member, despite (2) above, (i) not to act to moderate movements toward this range or (ii) to take action to moderate further divergence from the range. A member would not be asked to hold any particular rate against strong market pressure.
(4) A member with a floating exchange rate would be encouraged to indicate to the Fund its broad objective for the development of its reserves over a period ahead and to discuss this objective with the Fund. If the Fund, taking account of the world reserve situation, considered this objective to be reasonable and if the member’s reserves were relatively low by this standard, the member would be encouraged to intervene more strongly under Guideline (2) to moderate a movement in its rate when the rate was rising than when it was falling. If the member’s reserves were relatively high by this standard it would be encouraged to intervene more strongly to moderate a movement in its rate when the rate was falling than when it was rising. In considering target exchange rate zones under (3), also, the Fund would pay due regard to the desirability of avoiding an increase over the medium term of reserves that were recognized by this standard to be relatively high, and the reduction of reserves that were recognized to be relatively low.
(5) A member with a floating rate, like other members, should refrain from introducing restrictions for balance of payments purposes on current account transactions or payments and should endeavor progressively to remove such restrictions of this kind as may exist.
(6) Members with a floating rate will bear in mind, in intervention, the interests of other members including those of the issuing countries in whose currencies they intervene. Mutually satisfactory arrangements might usefully be agreed between the issuers and users of intervention currencies, with respect to the use of such currencies in intervention. Any such arrangements should be compatible with the purposes of the foregoing guidelines. The Fund will stand ready to assist members in dealing with any problems that may arise in connection with them.
Executive Board Decision No. 4232-(74/67)
June 13, 1974
Mr. Fleming, Deputy Director in the Research Department, is a graduate of Edinburgh University. He was formerly a member of the League of Nations Secretariat, Deputy Director of the Economic Section of the U. K. Cabinet Offices, U. K. representative on the Economic and Employment Commission of the United Nations, and visiting Professor of Economics at Columbia University. He is the author of Essays in International Economics and numerous articles in economic journals.
Meetings of the Committee on Reform of the International Monetary System and Related Issues (Committee of Twenty), a committee of the Board of Governors of the International Monetary Fund, in 1973–74. See the report, International Monetary Reform: Documents of the Committee of Twenty, published by the Fund (Washington, 1974).
The present paper represents in certain respects a development of some of the ideas referred to in John Williamson, “Increased Flexibility and International Liquidity” (not yet published).
The guidelines were adopted by Executive Board Decision No. 4232-(74/67). June 13, 1974. See Selected Decisions of the International Monetary Fund and Selected Documents, Seventh Issue (Washington, January 1, 1975), pp. 21–26. Also see IMF Survey, Vol. 3, No. 12, June 17, 1974, pp. 181–83; Annual Report of the Executive Directors for the Fiscal Year Ended April 30, 1974, Appendix II, J, pp. 112–16; and International Monetary Reform: Documents of the Committee of Twenty (Washington, 1974), pp. 34–36.
For a description and analysis of these proposals, see J. Marcus Fleming, Reflections on the International Monetary Reform, Essays in International Finance, No. 107 (Princeton University Press, December 1974).
The Outline of Reform was prepared by the Committee of the Board of Governors on Reform of the International Monetary System and Related Issues (Committee of Twenty) and was made public on June 14, 1974. It appears in International Monetary Reform: Documents of the Committee of Twenty (Washington, 1974), pp. 7–48. Annex 4 appears on pages 33–37.
International Monetary Reform, Annex 3, pars. 7–8, p. 32.
International Monetary Reform, Annex 4, Section C, p. 37.
Both the market value and the norm of a currency are expressed in terms of its effective exchange rate, that is, some average of its exchange rates.
Articles of Agreement of the International Monetary Fund, pp. 60 and 84.
International Monetary Reform, p. 14 and pp. 41–42.
John Williamson, “Exchange Rate Flexibility and Reserve Use” (unpublished, International Monetary Fund, August 29, 1974).
Effective world reserves may rise or fall on a massive scale as a result of the accumulation of surpluses by the oil producing countries, but these appear to be invariant with respect to the exchange rate system.
For the modus operandi of an asset settlement, see the Outline of Reform, Annex 5, Section A, in International Monetary Reform, p. 38.
The possibility that under a system of generalized floating the autonomous variations in the supply of reserves would be of so benign a character that no international control over their supply would be necessary is considered in the following section.
See, for example, J. Marcus Fleming, Essays in International Economics (London, 1971), pp. 95–101 and 190–91.