III Applications in IMF Surveillance Over Major Industrial Countries
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

The previous section demonstrated that hypothetical, retrospective assessments based on the macroeconomic balance framework would have performed quite well on those occasions during the 1980s and 1990s for which it is generally agreed that some of the major currencies were badly misaligned. But how are such assessments taken into account in actual IMF surveillance? This section looks at three cases, starting with the sharp movements of the U.S., Japanese, and German currencies in the spring of 1995, and then addressing the lira in the run-up to ERM reentry in the fall of 1996, and the appreciation of the dollar against the yen and deutsche mark in early 1997.

The previous section demonstrated that hypothetical, retrospective assessments based on the macroeconomic balance framework would have performed quite well on those occasions during the 1980s and 1990s for which it is generally agreed that some of the major currencies were badly misaligned. But how are such assessments taken into account in actual IMF surveillance? This section looks at three cases, starting with the sharp movements of the U.S., Japanese, and German currencies in the spring of 1995, and then addressing the lira in the run-up to ERM reentry in the fall of 1996, and the appreciation of the dollar against the yen and deutsche mark in early 1997.

Constellation of the U.S. Dollar, Yen, and Deutsche Mark, Spring 1995

Between December 1994 and April 1995, on a multilateral basis the real effective value of the yen appreciated by 19 percent, the deutsche mark appreciated by 7 percent, and the U.S. dollar depreciated by 9 percent. (From the beginning of 1994, the changes were 29, 10, and 14 percent respectively.) At the start of 1995, the IMF’s views on exchange rates between the three currencies were muted, reflecting differences of views about the confidence that could be placed in market judgments of exchange rates and the extent to which the IMF should publicize its concerns. But by early March, it had become increasingly clear that exchange rates between the major industrial countries had become misaligned relative to fundamentals. The judgment that policies should be adjusted in light of this misalignment was subsequently a key feature of IMF surveillance throughout the remainder of 1995.

In forming its judgment that the major currencies were misaligned, the IMF staff used various approaches. The staff’s estimates using the macroeconomic balance approach were combined with other measures of competitiveness, including estimates of purchasing power parity and trends in the trade accounts. The judgment that recent movements in exchange rates between the three currencies had gone farther than warranted by fundamentals coincided with then-prevailing perceptions that the buoyant U.S. economy would continue to grow rapidly during 1995 (albeit with some slowdown anticipated in response to increases in U.S. interest rates during 1994), while substantial margins of slack were present in both Japan and Germany. This led the IMF (by March 1995) to the view that concerted interest rate actions by the three countries—upward adjustment in the United States and downward adjustments in Japan and Germany—would be desirable for addressing both internal and external imbalances. These concerns were expressed publicly in the con-text of welcoming the Bank of Japan’s decision to cut its discount rate in April 1995.1 In that statement, the Managing Director of the IMF argued that “large and rapid” exchange rate changes posed a risk of higher inflation in the United States and weaker growth in Europe and Japan. He called for simultaneous and coordinated interest rate actions on the part of the three, reinforced by medium-term fiscal adjustment in the United States and Europe, and market opening measures in Japan. The view that exchange rates were out of line with fundamentals, but not the call for coordinated action, was echoed in the April 1995 Interim Committee communiqué, where “the Committee considered that recent exchange rate movements for some major currencies had gone farther than warranted by fundamentals and agreed that orderly reversal of these movements is desirable.”

The May 1995 World Economic Outlook avoided a public judgment that exchange rates were mis-aligned and instead focused on the mix of concerns that had weighed on markets and called for coordinated policy actions, along the lines of the Interim Committee’s Declaration on “Cooperation to Strengthen the Global Expansion” adopted at the Annual Meetings of the IMF in Madrid the previous fall. A feature common to all of the above statements was the focus on the need to reduce internal and external imbalances through improved fundamentals, which was not only aimed at moving exchange rates to a better international alignment but was also justified on domestic grounds.

In the event, while monetary policy was eased in Germany and Japan in response to weakening cyclical conditions, the case for higher interest rates in the United States was subsequently eroded by signs of a greater-than-expected slowdown in activity (partly reflecting spillovers from the economic crisis in Mexico), setting in motion a lowering of the federal funds rate, ultimately amounting to 75 basis points, from early July. Concerted intervention also contributed to a shift in market sentiment in favor of the dollar. With the benefit of hindsight, an increase in U.S. interest rates in the spring of 1995 would not have been helpful for the United States or the world economy. But the judgment that the major currencies were badly misaligned remains widely accepted among policymakers today.

Reentry of the Lira into the ERM

IMF staff used various methodological approaches in assessing the exchange rate of the lira in late 1995, at a time when the Italian government was considering the lira’s reentry into the ERM. Staff analysis indicated that Italy had a large underlying current account surplus at prevailing exchange rates, significantly exceeding the current account balance consistent with medium-term fundamentals. It was also recognized that the undervaluation of the lira evident at that time reflected market uncertainties about fiscal policies and expectations that inflation in Italy might well remain significantly above that in partner countries. Consistent with this view, lira-denominated assets were trading at large interest premiums. The IMF staff took the view that further front-loaded fiscal measures would provide the key to reducing uncertainty and would be likely to contribute to an appreciation of the currency.2 Only in this scenario would the preconditions for ERM re-entry be met.

In the event, with the approval in the spring of 1996 of a strengthened medium-term fiscal plan and an additional front-loading of fiscal consolidation announced in October 1996, with a view toward early EMU participation, the lira had appreciated substantially by the fourth quarter of the year. With declining inflation, the IMF staff’s analysis supported the lira’s reentry into the ERM within a range that included the central parity that was eventually chosen.3

Constellation of Major Currencies, Spring 1997

IMF staff analysis in the spring of 1997 supported the general conclusion that current levels of the yen, the dollar, and the pound had moved 10–20 percent beyond their medium-run equilibrium levels, and it was believed that these currencies could consequently be subject to some reversal of the recent movements in their multilateral values over the medium term. Parts of the estimated deviations from medium-run levels of the three currencies were matched by interest rate differentials, suggesting that markets also expected some realignment over time. In that context, and in light of cyclical conditions, the prevailing configuration of exchange rates was seen as broadly appropriate.4 By comparison with the constellation of the major currencies in early 1995, in the spring of 1997 the alignment of the yen was seen as alleviating the cyclical weakness of the Japanese economy, and the strong dollar also was not regarded as unhelpful from a cyclical perspective, given estimates that the U.S. economy was operating close to or above its potential output level.

Similar views were expressed by the IMF in its annual Article IV consultations. By the end of April, the exchange rate of the yen had fallen to a level that completely reversed its appreciation against the U.S. dollar since 1992. In concluding the Article IV consultation with Japan in August, Directors believed that the level of the yen was broadly in line with fundamentals.5 For the United States, Directors noted that the dollar’s appreciation over the past two years had been beneficial in moderating aggregate demand and in limiting inflationary pressures in the United States; it had also helped to sustain growth in other countries.6 Despite this, the strength of the U.S. economy relative to other major countries and the appreciation of the dollar was contributing to a widening in the external current account deficit, and the persistence of large U.S. current account deficits and growing international indebtedness would be a concern over the medium term.

1

IMF News Brief 95/12, April 14, 1995.

2

The preliminary conclusions of the IMF staff’s annual consultations with the Italian authorities were released by the authorities in December 1995.

3

For a discussion of these developments and of the lira’s ERM reentry, see ItalyRecent Economic Developments and Selected Issues, IMF Country Report No. 97/44 (Washington: International Monetary Fund), Section IV.

4

IMF, World Economic Outlook, May 1997.

5

”IMF Concludes Article IV Consultation with Japan,” Press Information Notice 97/19, August 13, 1997.

6

”IMF Concludes Article IV Consultation with the United States,” Press Information Notice 97/16, August 4, 1997.

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