Imbalances and Undervalued Exchange Rates: Rehabilitating Keynes

Post on the Financial Times' Economists' Forum

November 9, 2008

Getting countries with persistent current account surpluses to adjust obsessed Keynes because he was acutely aware of the limited leverage that could be exerted against such countries. Sixty years later, that problem continues to haunt the international financial system. The ongoing global crisis originated predominantly in poor national policies and regulation. But large current account surpluses, stemming in part from undervalued exchange rates, and the resulting liquidity surfeit was a facilitating factor.

Failure to address this issue by the Bretton Woods II process would be a serious abdication of responsibility by the financial system. Few issues are as central to the system or as much in need of multilateral cooperation.

Adding to the urgency of multilateral action will be US politics. If the US economy takes a downturn and the dollar continues to strengthen, a resurgence of protectionist pressures is likely. This time around, these pressures could well take the form of unilateral action against competitive currencies. It is noteworthy that President-elect Obama has actively and repeatedly supported action against "currency manipulation."

What multilateral action can help? Keynes' own idea for this problem was the so-called "scarce currency clause" in the International Monetary Fund (IMF) which envisaged trade and other actions by members against a country running persistent surpluses. It was the right idea but located in the wrong institution. It is time to rehabilitate Keynes' idea by adapting it to today's institutional realities.

Aaditya Mattoo of the World Bank and I have made a proposal along these lines.

The International Monetary Fund is, of course, the natural forum for addressing exchange rate issues. But the IMF suffers from problems of inadequate leverage and eroding legitimacy. The IMF has successfully changed the policies of countries that have borrowed from it. However, it has rarely, if ever, effectively influenced the policies of large creditor countries even where such policies have had significant negative effects on others. Moreover, emerging-market countries chafe at its governance structure, which reflects the receded realities of an Atlantic-centered 1945 rather than those of an ascendant Asia of the 21st century.

The World Trade Organization (WTO) is one alternative to the IMF, since undervalued exchange rates have large and direct trade consequences. What is needed is a rule in the WTO proscribing undervalued exchange rates that are clearly attributable to government action. An undervalued exchange rate is in effect a combination of export subsidies and import tariffs, each of which is currently disciplined by the WTO. The IMF would continue to be the sole forum for broad exchange rate surveillance. But in those rare instances of undervaluation, we envisage a more effective delineation of responsibility, with the IMF continuing to play a technical role in assessing when a country's exchange rate was undervalued, and the WTO assuming the enforcement role.

This change would be consistent with the WTO's better record on enforcement. Its dispute settlement system, although not perfect, has been reasonably effective in allowing members to initiate and settle disputes. Effectiveness, and indeed legitimacy, are related to the WTO being perceived as less asymmetric in the distribution of power between the industrial countries and emerging markets. Power and influence evolve organically in the WTO because they flow from market size rather than being historically determined as in the IMF. One sign of effectiveness and legitimacy is the fact that developing countries, even the smaller ones, have been as active in bringing disputes to the WTO for settlement as they have been at the receiving end.

How would this new rule against undervalued exchange rates be incorporated in the WTO? Through negotiation. The forthcoming Bretton Woods summit should place rules on undervalued exchange rates on the post-Doha trade agenda. The United States and European Union have been the principal demandeurs for action by China in the past. But it is important to remember that until very recently, a number of developing countries-Brazil, Mexico, Korea, Turkey and South Africa-were affected by the competitive pressure from the undervalued renminbi. Indeed, some months ago, the Indian Prime Minister urged China to follow a more market-based exchange rate policy. For obvious reasons, more emerging market countries have not voiced their concerns, but it is possible that a coalition of affected countries could unite on this issue.

Clearly, Chinese concerns have to be addressed for any new rules to be crafted and commonly agreed. Two possible carrots could induce Chinese cooperation and the Bretton Woods II process could work on this "grand bargain." First, China's major trading partners could pledge granting China the status of a "market economy" in the WTO contingent on it eliminating currency undervaluation and moving to a market-based system. This status would have significant value for China by shielding it against unilateral trade actions such as anti-dumping and countervailing duties by trading partners. Second, as part of radical governance reform of the IMF, which is desirable in itself, China should be offered a substantially larger voting share in the IMF commensurate with its economic status.

The problems of global imbalances and undervalued exchange rates have long eluded effective multilateral action. G-20 countries may well commit to more effective and coordinated action in the Fund to address these problems. But this has been tried-for 60 years-and comprehensively failed. To paraphrase Keynes, it is time to escape the tyranny of old ideas and try something new.

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Arvind Subramanian Senior Research Staff

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