With much fanfare, the International Monetary Fund’s Managing Director Rodrigo de Rato announced on June 18 that the Fund has adopted a new bilateral surveillance principle based on the concept of promoting “external stability.” This “new” principle is supposed to provide the Fund’s 185 members—especially China—with “clear guidance … on how they should run their exchange rate policies” and “on what is acceptable to the international community.”
The problem is that the Fund has never adhered to a firm principle of either freely floating exchange rates or truly fixed rates (as under the pre-1914 gold standard). Either of those two automatic adjustment mechanisms would eliminate the need for the Fund, whose purpose was initially to maintain an international monetary system based on “par values” and to adjust those values only in the case of a “fundamental disequilibrium” in a country’s balance of payments.
The Fund’s failure to prevent the Asian currency crisis in 1997–98 stemmed primarily from adherence to the flawed system of pegged exchange rates under IMF surveillance. That experience attests to the political nature of the Fund as a multilateral institution—and, hence, the need for compromising principles—rather than to its ability to enforce market-based rules.
There are four “principles” embedded in the Fund’s “2007 Decision on Bilateral Surveillance,” the first three of which derive from a 1977 ruling: (1) “A member shall avoid manipulating exchange rates … to gain an unfair competitive advantage over other members”; (2) “A member should intervene in the exchange market if necessary to counter disorderly conditions”; (3) “Members should take into account in their intervention policies the interests of other members”; and (4) “A member should avoid exchange rate policies that result in external instability.”
One of the key purposes of the new Decision is to clarify the meaning of “exchange rate manipulation.” It now means that a country purposefully maintains “an undervalued exchange rate,” or what the Fund calls “fundamental exchange rate misalignment,” to achieve a persistent trade or current account surplus. This interpretation implies that a persistent bilateral trade deficit is bad—a mercantilist doctrine that Adam Smith would contest.
The problem, as the IMF Factsheet admits, is that “While the concept of misalignment is clear, it is subject to significant measurement uncertainties.” Indeed, no one knows what the equilibrium exchange rate is in the absence of exchange-rate and capital freedom. There is no central planner or IMF economist who has the information to be able to calculate precisely what the “fundamental misalignment” is. It is not surprising, therefore, that the new Decision has no enforcement mechanism other than old-fashioned shunning.
In contrast to the IMF Decision, a new Senate bill introduced by Charles Schumer of New York and three other leading senators would allow anti-dumping duties to be imposed on countries with fundamentally misaligned currencies. Congress is impatient with China’s progress in letting the renminbi (also known as the yuan) appreciate against the dollar. Since July 2005, the RMB has only risen by about 8.5 percent. Although neither the IMF Decision nor the senate bill singles out China, there is no doubt who the main offender of “external stability” is in the minds and hearts of American “hawks” and protectionists.
Senator Schumer, who previously wanted lawmakers to impose a 27.5 percent tariff on all Chinese goods unless Beijing significantly revalued the RMB, stated, “The previous legislation got China’s attention; the purpose of this [new] legislation is to force change.” To do so, the Treasury will be compelled to report whether China has a “misaligned currency” aimed at promoting exports. That task will presumably be easier than determining if China “manipulates” its currency for a trade advantage.
Congress should be careful what it wishes for: a 20 percent or more appreciation of the yuan against the dollar would impose higher costs on millions of U.S. consumers and, more ominously, lead to higher U.S. interest rates that could topple the stock market and further depress the housing market. A recession may help diminish the U.S. current account deficit but it won’t be bullish for Congress.
China’s growing current account surplus reflects an imbalance in domestic saving and investment, a closed capital account, and an undervalued exchange rate. The fact that Chinese households and firms save a substantial portion of their incomes is largely a reflection of the distorted interest rates and the financial repression in China, in which state-owned banks and enterprises dominate the capital markets.
Making the yuan fully convertible and allowing further outward investment would increase personal and economic freedom but could jeopardize the fragile banking system. But keeping the current system risks creating inflation as the People’s Bank of China prints new yuan to support the dollar (though most of that liquidity is drained off by sterilization).
The IMF recognizes that external stability requires domestic stability and that institutions matter. The institution that China needs most is a transparent rule of law that protects persons and property against an intrusive state and that reduces corruption. But does anyone seriously believe that either the IMF or the U.S. Congress can bring about that monumental change in China?