Off Balance

by Paul Blustein

  All the while, the US Treasury was tightening the screws on IMF management and staff in its pursuit of a new decision that included the wording the Treasury wanted. The department’s officials weren’t shy about using the considerable leverage they held over de Rato’s own priorities, as a memo of an October 5, 2006 meeting shows. According to the memo, the Treasury’s Sobel spelled out some unfavourable consequences that would ensue if the revision of the 1977 decision was not handled to Washington’s satisfaction: the IMF would not be able to count on congressional approval of legislation needed for an agreement to change quotas, or shareholdings, in the Fund — and in the process, one of the key components of the managing director’s Medium-term Strategy would probably fail. “Mr. Sobel...made it clear that they considered the revision of the 1977 decision to be a critical part of a package of reforms seen to modernize the IMF, and that it would be difficult to ask Congress to support the quota reform if a new decision were not approved,” the memo said.

  Amid all these conflicting pressures, de Rato and his aides concluded that the time had come to abandon grand theory in favour of good old-fashioned coalition building as they intensified efforts in the spring of 2007 to bring the issue to the board for final approval. Most important, they jettisoned Principle E from the proposed decision — a bitter pill for true believers such as Allen, who cherished it for instilling the decision with symmetry. (They could take comfort by noting the presence of other language aimed at accomplishing the same goal, such as assertions that the decision would apply to countries with all manner of exchange-rate regimes.) In addition, language softening some provisions was added elsewhere — phrases emphasizing, for example, that the principles were “recommendations” for member countries rather than “obligations,” and that the IMF would give “the benefit of any reasonable doubt” to a country before deeming its currency fundamentally misaligned.

  By mid-May, the opposition of a number of developing-country executive directors was starting to weaken, according to emails among Fund staff. And further boosting the cause of revising the 1977 decision was a report issued that month by the IMF’s Independent Evaluation Office assessing the Fund’s conduct of exchange-rate surveillance from 1999 to 2005, which contained a long list of damning conclusions.6 Even so, the opponents had one last bombshell to drop. With just over a week to go before the scheduled June 15 board meeting, the G11 presented an alternative proposal for a new decision that removed all references to fundamental misalignment — which, as they well knew, made it totally unacceptable to the United States. De Rato agreed to negotiate with the G11 in the hope that its members were primarily seeking a few more concessions. “The MD really wants the Indians, Mexicans and Brazilians and maybe a few others to agree at the end of the day,” Allen told his colleagues in an email.

  6 See Independent Evaluation Office (2007), “IMF Exchange Rate Policy Advice,” May 17, available at: www.ieo-imf.org/ieo/pages/EvaluationImages109/aspx.

  Finally, at the June 15 board meeting itself, the necessary modifications were thrashed out, the agreement of those countries conferred, and the substantial majority of votes cast in favour, as related at the beginning of chapter 4.

  Given all the effort expended in winning approval of the decision, the champagne toast that followed in de Rato’s office reflected an understandable sense of accomplishment. Perhaps, though, the celebrants would have refrained from saluting their success if they had foreseen how muddled, impotent and spineless their institution would prove during the implementation phase in the weeks and months ahead.

  Three Big Targets

  On June 18, 2007, de Rato announced the basic facts regarding what had happened at the board meeting the previous Friday, telling an audience in Montreal that the IMF now had a new decision regarding its surveillance responsibilities. “It gives clear guidance to our members on how they should run their exchange rate policies, on what is acceptable to the international community, and what is not,”7 the managing director declared. He didn’t mention the handful of opposing votes, and of course remained silent on the identity of the countries that might be affected. That issue was the subject of a meeting of top staffers held on June 22.

  7 Rodrigo de Rato (2007), “Keeping the Train on the Rails: How Countries in the Americas and Around the World Can Meet the Challenges of Globalization,” speech at International Economic Forum of the Americas Conference of Montreal, Montreal, June 18.

  De Rato posed the question to his assembled aides: Now that the Fund had its new guidelines on exchange rates, which countries, and currencies, deserved to be singled out? Mark Allen was ready with a daring suggestion. The RMB may be the most obvious candidate, he argued, but two others should also be deemed fundamentally misaligned, albeit for different reasons: the Japanese yen and the US dollar.

  Targeting the IMF’s two largest shareholders was no small matter, but to Allen’s relief, the managing director didn’t flinch. De Rato shared Allen’s view that applying the label to several large countries would reduce the stigma to tolerable levels, making the whole exercise more practical, so he agreed with Allen’s list. “We need to apply the decision in as evenhanded a manner as possible,” he said, according to notes of the meeting.

  De Rato’s enthusiasm for the new decision also shone through in an “interim guidance note” he approved a few days later regarding how the staff should apply the decision in the writing of Article IV reports on member countries. The note, which the IMF did not release publicly, was, in essence, a call for ruthless truth-telling — a practice the managing director had previously shied away from. “Where staff assess that there is, beyond reasonable doubt, fundamental misalignment, the term ‘fundamental misalignment’ should be used in the staff report,” the note said.

  All of this news triggered alarm in the Fund’s area departments, where many staffers had opposed the decision and were dismayed to see that its implications might be even worse, from their standpoint, than they had thought. Not only might they be expected to apply the decision to the exchange rates of a good number of countries that they covered, they might have to write reports about those countries using language that struck them as pejorative. The Asia Pacific Department’s director, David Burton, wrote a memo to top management on July 5 arguing that “a good case can be...made for reserving fundamental misalignment for relatively extreme situations.” He denounced the idea of judging exchange rates in a “legalistic” and “mechanistic” way, adding: “We have already gone too far in this direction with the new surveillance decision, and we should avoid going any further if we can.”

  This reaction was predictable, because the area departments are much closer to the authorities in IMF member countries than are the “functional” departments such as PDR and Research. Although the area departments sometimes have unpleasant confrontations with the countries under their purview, they have strong incentives to avoid such situations. Mission chiefs generally seek to maintain cordial relations with a country’s finance ministry and central bank, partly because they want their advice to be taken, and partly because they fear that a clash with the authorities — especially in a big country that has clout at the Fund — might result in the finance minister calling the managing director to complain.

  So PDR was girding for fights with area departments over how countries would be surveilled — and top PDR staffers expected to win a fair share of those battles. This late-June message from Cottarelli to others in PDR conveys the department’s attitude:

  Colleagues, the meeting we had with management this afternoon showed that the MD supports the use of the term “fundamental misalignment” [FM] in staff reports whenever this is needed. In addition, it is clear that it would be very problematic to single out only China and another couple of countries as having a FM exchange rate....My suggestion would be to be fairly tough in discussing with area departments whether an exchange rate is fundamentally misaligned and to bring the issue to management if there is no agreement.

&nbs
p; It was all the more stunning for PDR when de Rato announced on June 28 that he would step down as managing director. Despite having two years left in his five-year term, he declared he planned to quit as soon as a successor could be named, he said, citing personal considerations. “My family circumstances and responsibilities, particularly with regard to the education of my children, are the reason for relinquishing earlier than expected my responsibilities at the Fund,” he said in a statement.8 (De Rato was divorced and had a couple of teenaged children living in Spain.) Considering how much of his legacy he had invested in winning approval of the 2007 decision, the chances seemed dicey at best that his successor would share his commitment to seeing the decision aggressively implemented.

  8 IMF (2007), “IMF Managing Director Rodrigo de Rato to Leave Following the 2007 Annual Meetings,” Press Release No. 07147, June 28, available at: www.imf.org/external/np/sec/pr/2007/pr07147.htm.

  What was certain was that the area departments were going to use every stratagem they could think of to prevent their countries from being labelled fundamentally misaligned. Regarding China, for example, the Asia Pacific Department reasoned that Beijing should be spared because of the likelihood that its currency would become properly aligned in the foreseeable future. A July 6 memo by Dan Citrin, the department’s deputy director, pointed out to IMF management that “if the current annual pace of appreciation [in the RMB] of around 5 percent were to continue over the next five years, this would lead to a cumulative 25 to 30 percent appreciation.” Once that factor was taken into consideration, “it may not be correct to classify China’s currency as being fundamentally misaligned,” Citrin asserted.

  Hoots of derision from PDR greeted this argument — which, as Cottarelli wrote in a July 9 email, “simply confirms that the exchange rate is currently misaligned, and would remain so in the absence of a sizable appreciation. This is the essence of a misalignment that is ‘fundamental.’”

  That didn’t matter, at least not right away. The battle of the RMB was put off until the following year, because the Chinese authorities insisted on additional discussions about their 2007 Article IV report, which simply lay in abeyance and was never submitted to either management or the board.

  But now that the IMF had moved into the implementation phase of the 2007 decision, fights over other currencies soon came to a head. The first of these fights involved the world’s most important currency.

  Dodging the First Bullets: The Greenback and the Yen

  On July 10, 2007, the US dollar effectively went on trial in the conference room of First Deputy Managing Director John Lipsky. Although it was a discussion among Ph.D. economists rather than a legal proceeding, the “charge” was fundamental misalignment, the “lead prosecutor” was Cottarelli, and the “defence attorneys” were two high-ranking economists from the Western Hemisphere Department, Ranjit Teja and Tamin Bayoumi. Serving as “judge” was Lipsky, thanks to de Rato’s pending departure. This proceeding was never supposed to be made public — a memo written by Cottarelli a few days later provides many of the details.

  This was the case the true believers in the 2007 decision had been fantasizing about from the start. A finding of fundamental misalignment in the Article IV report for the United States would not only make it much easier politically to apply the label to China, it would also show that IMF surveillance was becoming dramatically more even-handed.

  US Treasury officials were in high dudgeon upon hearing of the effort to target the dollar — which, in their view, simply confirmed that Fund staff and management were dodging their responsibilities. From the US standpoint, the main purpose of the 2007 decision was to toughen exchange-rate surveillance and name countries whose practices violated the norms of the system. So how would it look in Washington if the very first major country the Fund labelled was one that had a flexible currency and had made virtually no effort to exercise control over its currency level for over a decade? Why was the IMF sending the signal that it believed all major countries were equally deserving of opprobrium when the United States was allowing its currency to float freely, while only China was engaging in massive currency intervention, exchange controls and accumulation of reserves? Worst of all, how would Congress react?

  The fact that Lipsky was arbitrating the interdepartmental dispute did not bode well for the prosecution, because he was widely viewed within the IMF as sharing the Bush administration view that imbalances posed little risk to the global economy and that, in any case, US policies were not to blame. A year earlier, when he had emerged as the US choice for the number two post (Washington has traditionally controlled the job), his pending arrival aroused alarm among some at the Fund, notwithstanding his Stanford Ph.D. and long career as a chief economist at blue-chip banks and securities firms. A news article circulated among the staff said Lipsky “has long argued that the US current account deficit is not the danger many of his peers believe...not only was he a staunch supporter of...Bush’s programme of tax cuts, but he has attributed the US current account deficit to America’s relative economic strength rather than any shortage of savings.”9

  9 Tom Holland (2006), “New IMF Umpire Unlikely to Whip US into Line on Deficit,” South China Morning Post, May 23. In fairness to Lipsky, he proved correct in playing down the risks that many others feared, such as a collapse in the dollar. And critics, including the IMF’s own Independent Evaluation Office, have justly accused the Fund of having paid excessive attention to those risks while overlooking vulnerabilities in the financial system that would eventually prove far more serious.

  Still, the members of the prosecution team believed they had a reasonable case. Although the dollar was indisputably a free-floating currency, the board meeting of June 15 had endorsed language saying that all kinds of currency regimes were covered by the decision. And the degree of misalignment in the greenback appeared significant; with the US current account hovering at a record six percent of GDP in 2006, the Fund’s Research Department models estimated that the dollar was somewhere between 10 and 30 percent overvalued, that is, a fall of that magnitude “would be required to eliminate the misalignment relative to medium-term macroeconomic fundamentals.”10

  10 IMF (2007), “United States: Article IV Consultation — Staff Report,” July 11, available at: www.imf.org/external/pubs/ft/scr/2007/cr07264.pdf.

  In some ways, the IMF had already convicted the United States — at least on the charge of fomenting external instability. In a 2005 paper titled “Has Financial Development Made the World Riskier?” the Fund’s chief economist, Raghuram Rajan, had sought to raise the alarm, warning that skewed incentives in the financial sector were encouraging players to take huge gambles that could conceivably wreck the global system. Although Rajan didn’t accuse the United States specifically, it was clear that the worst excesses cited in the paper were to be found on Wall Street.

  But those concerns were not shared by the economists in the Western Hemisphere Department responsible for monitoring the United States. The prevailing view, as expressed in the 2007 Article IV report, was that the US financial system was a crucial source of the nation’s economic vitality. Indeed, this argument figured prominently in the meeting in Lipsky’s office. To justify the dollar’s high exchange rate, Teja and Bayoumi of the Western Hemisphere Department asserted that a fundamental shift in the demand for US assets had taken place, based on the nation’s financial efficiency. In other words, the dollar shouldn’t be viewed as overvalued, because it had acquired long-term strength stemming from the eagerness of foreign investors to pour money into a country where banks and securities firms were using the world’s most advanced and innovative techniques to invest capital. At the time, of course, nobody could have imagined how stupefyingly off-base this argument was.

  After two hours of debate, Lipsky issued his verdict — the equivalent of “not guilty,” as Cottarelli’s memo makes clear: “Mr. Lipsky concluded that the dollar should be regarded as ‘misaligned’ but not ‘fundamentally misaligned,
’” the memo says, adding that the main reasons were “(i) we do not have clear policy recommendations that would address the problem of the dollar misalignment in the near future; and (ii) we are not certain the United States are building up an unsustainable external position so we cannot conclude that the misalignment is ‘fundamental beyond reasonable doubt.’”

  In rendering his judgment, Lipsky attached considerable importance to the way the 2007 decision was ultimately written — specifically, the omission of the provision (“Principle E”) that was intended to deal with countries’ domestic policies. Without that provision, he reasoned, there was no way the IMF could label a country that had no foreign exchange policy. In any event, the difficulties of applying the term to other currencies began to mount at this point, just as the PDR team had feared. Also mounting were confusion and frustration about the whole undertaking.

  The Japanese yen, for example, was spared from being labelled fundamentally misaligned, for essentially the same reasons as those used in the case of the dollar, despite an estimate by the Research Department’s models that the yen was 15 to 30 percent undervalued. This evoked a series of piercing questions from executive directors when the board met on July 27, 2008 to consider Japan’s Article IV report. “If the yen is not fundamentally misaligned, and yet it is misaligned to the extent of 15 to 30 percent, and it is possible conceptually to have such a degree of misalignment in a completely floating and free exchange rate regime, what would trigger a serious thought of analysis to start examining that a particular currency is fundamentally misaligned?” asked Adarsh Kishore, India’s director, according to a transcript of the meeting. From the completely opposite perspective, the Japanese director, Daisuke Kotegawa, voiced perplexity that anyone would even go so far as to call their currency “misaligned” when, according to the staff’s Article IV report, Tokyo’s macroeconomic policies were “broadly appropriate.” Some of those present complained that, even after hearing the staff’s explanation of the fine points, they could no longer figure out what the terms used in the 2007 decision were supposed to mean. “To be very frank, I still have problems also in grasping the notion of fundamental misalignment,” said Willy Kiekens, a Belgian who represents 10 European countries.