17 Octobe 2017
The IMF Annual Meetings on 14-15 October in Washington, D.C. offered plenty of optimism with the usual dose of caution. The world economy experiences the broadest upswing since the 2000s. Downside risks remain important including political risks, market frothiness, rising debt levels. Yet, one of the more intriguing aspects was the communiqué of the International Monetary and Financial Committee (IMFC), that is remarkable in its emphasis on exchange rates. Since 2000, the IMFC has only very rarely if ever mentioned exchange rates. This time, exchange rates and the international monetary system featured prominently. It is likely a sign that IMF member countries want a more assertive approach on international economic policy matters.
The IMF was set up to monitor and manage exchange rates. Over the years though, it had seemingly lost interest in exchange rates or felt it was unable to exercise sufficient influence to make a difference. The IMF Articles of Agreement, the international treaty that established the IMF, says in Article I that the purposes of the IMF are inter alia "(i) to promote international monetary cooperation; [...] (iii) to promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation." The persistent high exchange rate volatility including of key international currencies suggests that the system the IMF is meant to supervise does not function as intended. It is the outcome of a near total lack of monetary policy cooperation.
The IMFC provides de facto the strategic direction of the work of the IMF. Its communiqué reflects merely what the IMF member countries or the most influential among them, the U.S., U.K., France, Germany and increasingly China, want the IMF to focus on. The communiqué mentions exchange rate 5 times compared with 1.2 times on average since 2000 (Chart 1).1 The near absence of exchange rates in earlier communiqués was indicative of the fact that the Governors of the IMF—the governments and central banks of the IMF member countries—do not want to talk about exchange rates. What changed? Possibly, rising concerns that high exchange rate volatility has real adverse welfare implications. While asset prices have seen very low levels of volatility recently, exchange rates have not. Exchange markets have for some time been the main gauge for market fear (see also Fear gauge).
Exchange rates are of course simply the collective prices of one country expressed in the currency of another country. Assuming all available information is embedded in current prices, then exchange rate volatility is due to unanticipated relative price changes between countries amid inflation surprises and other unforeseen shocks. The more surprises countries produce or the more they are perceived to produce surprises the greater exchange rate volatility will be. The less countries are aligned cyclically with one another and the less economic policy cooperation there is among them, the more likely they are to diverge price-wise or produce asymmetric price shocks.
The persistent high levels of exchange rate volatility shows an increasing inability of market participants to gauge price developments in different countries. Those price developments, including asset and other prices, naturally depend on economic activity and economic policy. The risks of an uncoordinated exit from unconventional monetary policies amongst the most important central banks is a case in point. However, even prior to the global financial and economic prices, exchange rates moved significantly despite increasing price level convergence (Chart 2). The inflation targets of the big advanced economies central banks, the Federal Reserve, ECB, Bank of Japan and Bank of England are all set at 2 percent. Exchange rate volatility between those currencies should be very low.
The IMFC communiqué also mentions the international monetary system. It referred to the system 2 times compared with only 0.3 times on average since 2000 (Chart 1). Only in 2010, when France, using its presidency of the G20, pushed but never followed-up on the need to reform the system was it mentioned 2 times. The system encompasses the central banks and the IMF to manage international liquidity with international reserves and other means to provide sufficient foreign exchange to allow orderly cross-border transactions and balance of payments adjustment. The lack of adequate liquidity is naturally the main cause for heightened exchange rate volatility. In that context the communiqué also indicates that the role of the Special Drawing Right (SDR) of the IMF will be re-examined for its possible broader use (see also comments on the Special Drawing Right).
The international monetary system has seen some though few critical reforms. In rests in large part still on the dollar to provide international liquidity (see Time to transform the world's currency system). While the level of international reserves at about 11 trillion dollars or 14 percent of world GDP is unprecedented, though down from previous highs, the deployment of reserves remains inadequate and the distribution of reserves highly uneven (see also Central bank reserve update). Peripheral support through IMF facilities and central bank swap lines have remained marginal. Other measures to mitigate cross-border financial flows through macroprudential measures and other means have also not had a significant impact
The IMFC communiqué may announce at last a new momentum towards reforming the international monetary system. It also likely reflects China's mounting influence that has taken an active interet in the issue. Recent academic publications indicate that academics, with few decisive contributions for decades, are warming-up to offer needed intellectual support.2 The system has not seen important innovations since the introduction of flexible exchange rates in the 1970s and remains the most unreformed part of the international economy. The scope for reform is therefore substantial. The potential implications are vast for international trade, investment and international stability.
1 The communiqués referred herein are those issued during the IMF Annual Meetings only. See Communiqué of the Thirty-Sixth Meeting of the International Monetary and Financial Committee (IMFC), 14 October 2017, Washington, D.C.
2 The Journal of Economic Perspectives in its current issue offers a symposium on the global monetary system. The upcoming Annual Meeting of the American Economic Association has several sessions dedicated to the topic.