Abstract

In its surveillance activities, the Fund is frequently confronted with the difficult problem of how to identify exchange rate behavior that is unrelated to underlying economic and financial conditions and, consequently, should be viewed with concern from a national or international standpoint.1 This paper considers the various issues related to this problem as it pertains to industrial countries, both those that have independently floating exchange rates and those that operate under other exchange arrangements.2 The main issues are (1) the considerations that are important in determining whether an exchange rate deviates substantially from its sustainable level; (2) the degree of confidence that can be attached to judgments of the sustainable exchange rate; and (3) the relevant policy implications from the standpoint of Fund surveillance. These issues have been discussed extensively in the past, and it is not the purpose of this paper to introduce new concepts. Rather, the intention is to survey the techniques that are typically employed by the Fund staff and to provide an analysis of their practical usefulness.

In its surveillance activities, the Fund is frequently confronted with the difficult problem of how to identify exchange rate behavior that is unrelated to underlying economic and financial conditions and, consequently, should be viewed with concern from a national or international standpoint.1 This paper considers the various issues related to this problem as it pertains to industrial countries, both those that have independently floating exchange rates and those that operate under other exchange arrangements.2 The main issues are (1) the considerations that are important in determining whether an exchange rate deviates substantially from its sustainable level; (2) the degree of confidence that can be attached to judgments of the sustainable exchange rate; and (3) the relevant policy implications from the standpoint of Fund surveillance. These issues have been discussed extensively in the past, and it is not the purpose of this paper to introduce new concepts. Rather, the intention is to survey the techniques that are typically employed by the Fund staff and to provide an analysis of their practical usefulness.

In this paper, the concept of sustainability is given its traditional broad meaning; that is, an exchange rate is viewed as sustainable if it can be maintained over the medium term and is “appropriate” from the standpoint of the country in question and the international community as a whole. It is important to employ this rather broad definition of sustainability because experience suggests that a wide range of exchange rate levels could be maintained for an extended period by, for example, undue restrictions on trade and payments, severe restraint of aggregate domestic demand, or massive external borrowing. Such conditions might cause the level and structure of domestic output and employment in both the country in question and also—if the country was relatively large—in its trading partners to deviate substantially from that which would be appropriate from the viewpoint of an efficient international allocation of resources.

Several aspects of the concept of a sustainable exchange rate merit emphasis. First, it is the rate that is consistent with a viable medium-term pattern for the overall balance of payments, including the current and capital accounts, and an adequate but not excessive rate of accumulation of net official foreign exchange reserves. In particular, it should reflect not only the competitive position of the country in the international market for goods and services, but also the country’s propensity to be a net importer or exporter of capital. Second, a country’s sustainable exchange rate cannot be determined in isolation from developments abroad, particularly among its major trading and financial partners; for example, it depends on the overall stance of policies both at home and abroad. Third, as long as inflation rates and other underlying economic conditions continue to differ among countries, the sustainable level of each country’s nominal exchange rate may change over time. It is only for purposes of simplification that this paper refers to a sustainable level of the exchange rate, rather than a sustainable time path.

It is often a difficult matter to judge whether an exchange rate that can be maintained over the medium term is also the appropriate rate. This question touches on some very broad issues of economic policy. For example, if a country adopts a fiscal policy that leads to a persistently higher level of its fiscal deficit, it may experience a rise in its domestic interest rate and—if the expected inflation rate does not increase—an appreciation of its exchange rate, leading to a current account deficit financed by larger inflows of interest-sensitive capital. Such a pattern may be a source of concern for the international community; in practice, however, the issue of whether a given change in fiscal policy goes beyond the bounds of acceptability from the international standpoint is obviously a matter of judgment. A second example is the country that makes active use of policy measures to depreciate its exchange rate in order to mitigate the adverse effects of cyclical developments abroad on its domestic output and employment. Here again, it is clearly not an easy matter to differentiate between an appropriate response and one that goes beyond a mere attempt to insulate the domestic economy from adverse economic developments abroad.

The Fund is continuously faced with the need to reach judgments on whether countries’ exchange rates are sustainable, or whether they might potentially give rise to undesirable balance of payments developments and, at a later stage, to sharp and costly exchange rate movements.3 When a member country pegs its currency or participates in a cooperative exchange arrangement, the authorities are obliged to notify the Fund promptly of any changes in their exchange arrangements, and the Fund is required to assess the appropriateness of the new rate. Furthermore, whatever exchange rate regime a country operates, the Fund is charged with the responsibility of appraising the behavior of the exchange rate and, particularly, of identifying any “behavior of the exchange rate that appears to be unrelated to underlying economic and financial conditions, including factors affecting competitiveness and long-term capital movements,”4 in order to ensure that exchange market developments are consistent with the country’s obligations under the Articles of Agreement. The Fund’s responsibilities arise essentially in a multilateral context; thus the Fund’s judgment of a member’s exchange rate must be consistent with its assessment of the set of exchange rates that can be maintained and is appropriate among its members. This consistency aspect is a crucial element of Fund surveillance.

Fund-supported programs often involve specific exchange rate understandings, and the Fund’s regular Article IV consultations with member countries normally encompass the issue of the appropriateness of the exchange rate. A judgment that the existing exchange rate is unsustainable does not automatically imply a precise view of what the sustainable rate is. For example, heavy and persistent intervention may lead to a judgment that the rate should be changed, yet provide little guidance on what the new rate should be. In the context of surveillance, however, it is seldom sufficient to advance the view that the current level of the exchange rate is unsatisfactory without giving any indication as to what would constitute a satisfactory range. Such judgments must be made with due regard to both the inherent uncertainties that exist in the determination of a sustainable exchange rate and the nature of the present international monetary system, which permits a substantial degree of exchange rate flexibility.

The Fund’s approach to the problem of assessing the sustainable exchange rate makes use of various elements. A number of indicators, particularly measures of international cost and price competitiveness, have been developed and used as an integral part of the analysis that forms the basis of the staff appraisal that concludes reports on Article IV consultations with each member country, and, more recently, as part of the system of regular notification to the Executive Board of major changes in real exchange rates that was instituted by the Fund in March 1983.5 It has always been recognized, however, that there are important limitations to a judgment based exclusively on considerations of international competitiveness. In particular, such a judgment does not take into account the likely effects of recent policy changes or developments affecting the underlying capital account position of the balance of payments. Thus, throughout the 1970s, the Fund staff carried out research to develop and apply a more comprehensive multilateral approach that could be used to estimate the underlying external payments positions of industrial countries. These estimates were incorporated in various reports to the Executive Board. More recently, to attain a better understanding of the factors that can lead actual market exchange rates to deviate from their sustainable levels, the Fund staff has also carried out research on the shortrun determinants of floating exchange rates, including interest rate differentials and international portfolio shifts.

Section II of this paper surveys some general aspects of exchange rate determination among industrial countries, emphasizing particularly the role of capital mobility and developments in financial markets, and their implications for exchange rate overshooting. Section III discusses the use of information on international price competitiveness in the assessment of the sustainability of a country’s exchange rate. Section IV broadens the discussion to the underlying payments balance approach, which takes account of a number of important considerations in addition to price competitiveness, thereby providing more comprehensive and internationally consistent judgments about the set of exchange rates that would be appropriate for industrial countries. Finally, Section V provides some concluding comments.

1

In this sentence, and hereafter, the term exchange rate is used as an abbreviation for the effective exchange rate, except where explicit reference is made to bilateral rates.

2

Among the twenty members of the Fund that are classified as industrial countries, four broad categories of exchange arrangements are currently in use. The currencies of five of the major industrial countries (Australia, Canada, Japan, the United States, and the United Kingdom) are floating independently. Eight European countries (Belgium, Denmark, France, the Federal Republic of Germany, Ireland, Italy, Luxembourg, and the Netherlands) operate within the cooperative exchange arrangements of the European Monetary System. Four other European countries (Austria, Finland, Norway, and Sweden) peg their exchange rates to a composite basket of currencies. Finally, there are three countries (Iceland, New Zealand, and Spain) that are classified by the Fund as operating a system of “more flexible” exchange arrangements.

3

In particular, these issues are at the heart of the Fund’s obligations under Article IV, Section 3 of the Amended Articles of Agreement, which states that “the Fund shall oversee the international monetary system,” and “shall exercise firm surveillance over the exchange rate policies of members.” An important aspect of the Fund’s surveillance activities is to ensure that countries respect their obligations under Article IV, Section 1 (iii), including the obligation 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.” The obligations of the Fund and of its members in the area of exchange rate policies were specified in greater detail in the implementing decision “Surveillance over Exchange Rate Policies” (Decision No. 5392(77/63), adopted April 29, 1977).

4

“Surveillance over Exchange Rate Policies,” Decision No. 5392-(77/63), Selected Decisions of the International Monetary Fund and Selected Documents, Tenth Issue (Washington, 1983), pp. 10–14.

5

This system is described in IMF, Annual Report of the Executive Board for the Financial Year Ended April 30, 1983, p. 65.