On Monday, the International Monetary Fund announced the first update of its foreign-exchange surveillance mechanism in three decades. Aside from some media coverage, which was generally descriptive in nature, there was little fanfare. Yet there seem to be some potentially far-reaching implications that have yet to be grasped.
Previously, the IMF had three principles about currency regimes. First, countries should not manipulate the foreign-exchange market to prevent balance-of-payment adjustments, giving an unfair competitive advantage. Second, intervention can be undertaken if markets are disorderly. And third, when countries do intervene, they should take into account the impact on the currency they are intervening against.
To these, the IMF has added a fourth principle: Members should avoid exchange-rate policies that result in external instability. This is not inconsequential. Rather than simply another principle, the IMF is placing it at the center of its surveillance efforts.
It is a long time coming. The U.S. has been pushing in this direction for the last couple of years and, perhaps less formally, since the end of the Asian financial crisis that is about to celebrate its 10th anniversary.
Two Extraordinary Effects
It turns orthodoxy on its head in two important respects. First, traditionally, the burden of the adjustment has fallen on the deficit, or weaker, country. At Bretton Woods, Keynes argued that the surplus country should also have a responsibility, but the U.S., the main surplus country at the time, insisted on the traditional approach.
It wasn't until after Bretton Woods collapsed and Europe was seeking to avoid dramatic exchange-rate movements between its members that surplus countries, such as Germany, had a responsibility to defend currency bands, such as against Italy.
This new principle clearly shifts the burden away from the U.S. and deficit countries to surplus countries, especially China, and, to some extent, Japan and the oil exporters.
Second, the new principle also breaks from the past, insofar as it gives greater saliency to "external stability." Realism and realpolitik has meant that in lieu of a world government, countries would pursue their own self-interest. Now sovereigns are being told that the systemic needs (external stability) are of greater importance.
Of course, there are ways to square the circle. It is not necessarily zero sum. Proper national policies and balanced growth on a domestic level will help foster external stability.
However, this runs against the main current of market-based economics and liberty. Adam Smith argued that it is precisely by individuals pursuing their self interest that the general interest will be achieved. The "invisible hand" turned private vices (e.g. greed) into public virtues (prosperity).
That said, this change at the IMF reflects an important evolution in the thinking of policy makers. The Great Depression and World War II convinced many policy makers that the dramatic swings in the business cycle could threaten democracy and liberty. Voila. As Nixon quipped, "We are all Keynesians" -- counter-cyclical government action has not ended the business cycle, but it can mitigate the downturn and make the cycle longer and flatter.
The Dangers of Instability
The liberalization of the capital markets helped absorb the shocks created by modern economies so that the economies themselves could be more stable. However, there were then a series of emerging-markets crises, beginning with Mexico in 1994 to 1995 and extending through the Asian financial crisis and Argentina in 2001 to 2002.
Among the lessons policy makers drew from that period was that the volatility of the capital markets themselves could create feedback loops and not only undermine the underlying economies but also threaten democracy and liberty.
Consequently, there was recognition, perhaps among the highest echelons of policy makers, of the importance of fostering international financial stability. At the same time, the emergence of China -- which was bound to be disruptive regardless, given its size and vast pool of cheap labor -- is sparking anxiety of all sorts.
This despite the fact that the world economy is set to grow around 5% for the fourth-consecutive year and that the major industrialized countries -- from the U.S. to the UK to the Euro zone and Japan -- are also posting multiyear lows in unemployment. If these anxieties are not addressed, the danger is a protectionist political backlash, which is understood by top policy makers as putting the global economy at risk.
Descending Into Irrelevance?
Yet the IMF may be overplaying its hand. Given the significance of China to the whole debate -- even though, of course, the IMF did not cite it, per se -- it is a shame that a greater effort was not done to win it over. China and a couple of other countries opposed the new measure, understanding it was aimed at them.
Moreover, it seems disingenuous to make these changes, broadening the scope of the IMF's surveillance without first making the institution more reflective of economic realities. The weighted votes are supposed to be rejigged in a preliminary fashion late this year before more-thorough reform is implemented.
But officials have put the cart before the horse. The IMF has a credibility issue that has not been addressed. Perceptions, only enhanced by the 1997-1998 Asian financial crisis, that the IMF does Washington's bidding may be strengthened by these new reforms.
Although policy makers may have been trying to make the IMF more relevant, the risk is that it becomes more marginalized. For at least 10 years, many Asian countries wanted to develop their own regional IMF. Although an institutional framework has not crystallized, the creation of an extensive network of swap lines and possibly pooling reserves are preliminary steps in that direction.
Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;
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