The 2007 decision was clearly in trouble — and an even bigger setback was looming, this time involving one of the world’s least important currencies.
The Scarlet FM
The Maldives rufiyaa, which was pegged against the US dollar, was fundamentally misaligned by pretty much any sensible interpretation of the 2007 decision — on that, Deputy Managing Director Takatoshi Kato agreed with PDR economists. So on July 30, for the first time, the executive board met to discuss an Article IV report in which IMF staff, with management’s blessing, applied the label to a country’s currency. But now those who had championed the 2007 decision had to explain why, after the United States and Japan had avoided being labelled, harsher treatment should be accorded to an island nation whose entire population would fit in three large football stadiums.
“There is no doubt that this is an awkward issue, and we certainly among others regret that Maldives is the first case where we’re having...this debate,” said Michael Kaplan, who was representing the United States at the meeting, according to a transcript.
Representing the IMF staff that day was Mark Allen, who as head of PDR wouldn’t ordinarily attend the annual board review of a country so small. He was there because he knew that if the directors rejected the staff assessment, “we run the risk of creating a precedent that will make our life difficult in the future,” as he had put it in a memo a few days earlier.
Allen elucidated the economic reasoning behind the staff report, which boiled down to the following: Maldives was running an absurdly high fiscal deficit — about 28 percent of GDP — that was utterly inconsistent with its pegged currency. If it continued, the deficit would lead to a run on the rufiyaa, a drain on reserves and a collapse in the fixed exchange rate, Allen asserted. He gave a step-by-step account of how the staff had first looked at the “underlying” current account deficit of Maldives (meaning it was stripped of temporary factors), and then finding that it deviated significantly from an equilibrium level “consistent with the economy’s structure and fundamentals.” Even though this didn’t necessarily mean that the government was wrong to keep the rufiyaa pegged to the dollar, it did imply that the fiscal policy was “unsustainable,” he said.
Then Allen squarely faced the sensitive issue of why such a tiny country was seemingly being singled out. “Maldives is similar to those of the US and Japan in that the root cause of misalignment is domestic policies and not the exchange rate policies,” he said. “But...we are confident that misalignment is significant enough to be termed fundamental.” This differed from the US and Japanese cases, where there were “reasonable doubts” about whether the misalignments were so large, because of uncertainties about issues such as shifts by Japanese investors toward foreign assets.11 “We believe in the case of Maldives, it is really very, very clear cut,” he concluded.
11 Allen was voicing the official position of IMF staff and management on this point, even though — as previously noted — he personally held the belief that both the United States and Japan should have been deemed fundamentally misaligned.
Precious few directors were convinced. Egypt’s Shaalan, whose constituency included the Maldives, rebutted Allen by assuring his colleagues that the Maldivian authorities understood the need for budgetary prudence and would take action to minimize any risk to their currency. “Not a single member of this institution has had the honor” of being labelled fundamentally misaligned, he noted. “Surely we do not wish our first assessment of fundamental misalignment to be attached erroneously to this small island economy, that you have all noted is very fragile and vulnerable.” (The country was still recovering from the 2004 tsunami.) Another director used the word “crucifying” to describe the accusation against the Maldives, while several others voiced skepticism about the claim that the island nation’s circumstances were qualitatively different from those of the bigger countries that the board had just considered. “I remember that for Japan and for the US...it was assessed that the currency was overvalued and in the other case undervalued, probably to a large margin,” said Belgium’s Kiekens. “But not fundamental. Here it is fundamental...I wonder whether we can go public with concepts that are not yet clearly explained.”
The precedent that Allen had dreaded was set. Only directors from the United States, Germany and the Nordic countries supported his position, so the staff’s finding of FM received no official Fund endorsement. Summing up the majority view, the IMF’s Public Information Notice about the meeting said that “many Directors noted that adequate information was not available to make a determination whether or not the Maldives’ exchange rate is in fundamental misalignment.”12
12 IMF (2007), “IMF Executive Board Concludes 2007 Article IV Consultation with Maldives,” Public Information Notice No. 07/100, August 9, available at: www.imf.org/external/np/sec/pn/2007/pn07100.htm.
Just a month and a half had passed since the day of the champagne toast in de Rato’s office, and it seemed clear that neither the board, nor management, nor much of the staff had the stomach to use the 2007 decision as its drafters had originally intended. The “scarlet M” had turned into the “scarlet FM.” The big question remaining was whether it might be applied in the case of the country whose foreign exchange policy had inspired the term.
The Battle of the RMB
Frustration over China’s treatment by the IMF was reaching the boiling point among US Treasury officials in the spring of 2008. By that point, Dominique Strauss-Kahn, who succeeded de Rato in the fall of 2007, was heading the Fund, and although the former French finance minister took charge with breezy confidence, Treasury officials were obliged to wait patiently as he settled into the job. Strauss-Kahn was, by all accounts, appalled at the mess he had inherited regarding the 2007 decision, and had been able to defer making hard choices about the toughest cases as he devoted his energy to other tasks aimed at ensuring the Fund’s future viability. He devised a plan to save US$100 million from the IMF budget by cutting staff, with the proviso that member countries would agree to sell a portion of the Fund’s gold stocks, which would create an endowment for financing operations.
But by the spring of 2008, pressure for action on the currency front was building as a backlog of Article IV reports was accumulating for countries that were potential candidates for the FM label. These included Malaysia, Latvia, Fiji and Seychelles — with China looming over them all.
The IMF had been unable to finalize a staff report calling the RMB fundamentally misaligned, much less convene a board meeting to endorse such a finding. Ever since approval of the 2007 decision, the Chinese had made sure that their economy would not be subjected to that type of affront, by asserting that they needed further discussions to make their case — and there was no easy way for the Fund to force the issue. To be sure, one of the obligations of IMF members is to submit to regular Article IV surveillance; the managing director can technically put any country’s review on the agenda for a board meeting, which can be changed only if a board majority votes to do so. But in practice, a single board member can usually arrange a long postponement by claiming the need for time to hold additional consultations. This is because of the diplomatic niceties that govern board conduct, as well as the recognition by each member that he or she may wish to be accorded similar courtesy in the future. In China’s case, one board meeting was “tentatively scheduled for March” 2008, then another “after the spring meetings, perhaps by May,” another “in the second or third week of June,” and yet another “before the August recess,” according to IMF staffers’ emails. But none of these materialized.
On April 25, the Treasury’s Sobel met with IMF staff and conveyed his department’s displeasure “with great conviction,” according to a memo of the encounter by van der Willigen, who summed up the Treasury’s message as follows: “Getting the China Article IV done, with an FM finding, is crucial, and it needs to be done sooner rather than later, as the delay has already damaged credibility and may soon do so beyond repair.” This was
not just tough talk: the Americans once again had greater-than-usual leverage because the IMF’s plan to sell gold stocks required passage of legislation in Congress. According to the memo, Sobel’s “top level message was that the Fund needs to give clear signals when a country is offending against the rules of the international monetary system, and that it is impossible to defend the Fund before Congress if it does not do this.” What was more, the same table thumping was evidently occurring at much higher levels, between Strauss-Kahn and Treasury Secretary Henry Paulson. As the memo put it, Sobel “was clearly very aware that his boss was simultaneously giving a take-no-prisoners message to DSK.”
IMF management and staff, therefore, began moving forward in the weeks following with efforts to label the RMB as fundamentally misaligned, despite warnings from Chinese officials that such an act would be “totally unacceptable” (a phrase cited repeatedly in IMF emails concerning conversations with the Chinese). On May 16, the Fund threw down the gauntlet in the form of a memo from Deputy Managing Director Kato to China’s Ge, which spelled out how the process of labelling would work:
As we discussed the other day [Kato’s memo said], below is the language that reflects our current assessment of China’s exchange rate and exchange rate policies in accordance with the 2007 surveillance decision....The language envisaged is as follows:
Despite recent appreciation against the US dollar, the renminbi is judged by the staff to be substantially undervalued, indicating a fundamental misalignment in the exchange rate. Moreover, China’s continued tight management of its exchange rate significantly contributes to external instability.
In support of this conclusion, Kato’s memo cited the quadrupling of China’s current account surplus — it had swelled to 11 percent of GDP in 2007 — and the quintupling of official reserves, to US$1.7 trillion, over the previous five years. Kato also expressed hope that a recently postponed IMF mission to Beijing could be rescheduled promptly, with the aim of proceeding toward the finalization of the Article IV report.
A frosty retort was soon forthcoming from Ge. After noting that the RMB had appreciated 18 percent against the dollar, and 12 percent in real effective terms, since July 2005, the Chinese executive director wrote back to Kato on May 27, 2008:
In early 2008, South China was hit by a severe snowstorm and just two weeks ago, Sichuan province was struck by a devastating earthquake....Since the reform of the exchange rate regime, a large number of export enterprises experienced bankruptcy and loss of jobs. Even in this difficult situation, the Chinese authorities have continued to implement policy measures to correct the external imbalances, including exchange rate flexibility.
We hope that the Fund will continue to carry out its duty as a trusted advisor to members....Rushed judgment before frank and comprehensive discussions should be avoided.
Meanwhile, the Chinese authorities are preoccupied with earthquake relief and reconstruction, and it is extremely difficult to accommodate a consultation mission at this time.
Behind China’s hard-nosed stance was more than just a desire to defend national dignity. Beijing was also concerned that an IMF finding of FM might lead to economic sanctions against it; documents show that Chinese officials sought advice from the Fund’s legal department on how vulnerable their country might be to sanctions. The Fund itself has no practical enforcement powers over members unless they are borrowing its money. But if the RMB was adjudged to be fundamentally misaligned, that could raise the likelihood of China’s trading partners bringing cases against it at the WTO, which, as noted previously, does have the power to authorize the imposition of various penalties including punitive tariffs. And in addition to the prospect of a WTO complaint, China had ample reason to worry about increasing its vulnerability to unilateral sanctions by the United States, since the Grassley-Baucus bill used the same standard — FM — as the 2007 decision. The bill had been combined with tougher legislation, and envisioned that countries with fundamentally misaligned currencies might be subject to a variety of punishments, such as reduced protection from anti-dumping complaints.
The Chinese needn’t have gotten overly anxious. A number of forces were converging against those who would besmirch Beijing’s foreign exchange policy.
Lehman Changes Everything
A subtle power shift was underway within the IMF. No longer was China isolated; on the contrary, it had gained plenty of new allies. The near-unanimous support on the board that had briefly coalesced behind the 2007 decision at the time of its approval was evaporating, amid growing resentment toward the American treatment of the Fund. Further damaging the US position was mounting evidence of the fragility in its financial sector, the most salient manifestation being the downfall of the investment banking firm Bear Stearns in mid-March 2008. These developments showed all too clearly whose economy had eluded tough IMF surveillance.
Even European executive directors, who had once solidly backed the 2007 decision, were increasingly favouring the Chinese position. The reason for this was not so much the merits of the arguments regarding the labelling of the RMB, rather, it was because the Europeans wanted to help protect one of their own — Latvia — from a similar fate.
The Latvian let was as clear a case of FM and external instability as the IMF staff could find — a problem of overvaluation rather than undervaluation. The exchange rate of the let was fixed against the euro in preparation for entry into the euro zone, which had helped generate super-fast growth and massive inflows of foreign capital, but also the classic symptoms of an overheated, crisis-prone economy, including a real estate bubble that was starting to implode and a current account deficit well above 20 percent of GDP. Based on IMF models, the let was overvalued to the tune of 17 to 37 percent, which posed a serious danger to its neighbours because a collapse of the currency regime would almost certainly have knock-on effects throughout the Baltic region and elsewhere in Eastern Europe where other currencies were also tied to the euro. But the risk of such spillovers was precisely why the Europeans were adamantly resisting the IMF labelling Latvia as fundamentally misaligned, since it could spark the very crisis the Fund feared. Swedish banks, which had lent heavily to Latvians, were particularly exposed to a currency crisis, and Jens Henrikkson, the Swede who then represented the Nordic countries on the board, was using every available tactic to keep Latvia’s Article IV report from being completed, including exercising his authority to block a staff mission to the capital, Riga, IMF email messages show.
Caught in the middle of all these irresistible forces and immovable objects was Strauss-Kahn, who knew that if he brought either the Chinese or Latvian Article IV reviews to the board, he would be unable to win a majority in favour of labelling the currencies as fundamentally misaligned. Yet the US Treasury was unrelenting, as revealed by notes of meetings the managing director held in mid-June 2008 with G7 officials. In one tête-à-tête with Thomas Mirow, state secretary of the German Finance Ministry, Strauss-Kahn said: “The US wants to label the Chinese. Paulson says that if we don’t use the 2007 decision, the Fund is dead...[It’s] blackmail. If there is no solution [that suits] the US, it could endanger congressional votes” that the Fund badly needed for the sake of its own financial viability. Although Treasury officials understood that sentiment among executive directors was now heavily against labelling China, they still wanted Strauss-Kahn to bring the matter to the board, which would at least throw his personal weight behind a condemnation of the Chinese foreign exchange regime.
The endgame for the 2007 decision was now at hand. Playing for time, the wily Strauss-Kahn devised a scheme, requiring a modest modification of the decision, that he hoped would satisfy Washington while providing at least a modicum of face-saving for Beijing. Under his plan, when the Article IV report of a country such as China was up for board review, the managing director could notify the board of his “significant concerns” that the currency was fundamentally misaligned,13 which could lead the board to initiate “ad hoc consultations” — but the
formal labelling would be postponed for six months, giving the country a chance to adjust its policies. After the board gave its assent (over US misgivings) to this new approach, it was unveiled for the news media on August 12, 2008.14
13 The “significant concerns” could also apply to other violations of the 2007 decision.
14 IMF (2008), “Transcript of a Conference Call on the 2007 Surveillance Decision,” August 12, available at: www.imf.org/external/np/tr/2008/tr080812.htm.
At that point, a showdown at the board on China was scheduled for September 22 — which, at the time, no one knew would come exactly one week after the most catastrophic financial episode in generations. The staff was putting the finishing touches on its 2008 Article IV report for China — which would never see the light of day. Here is the crucial wording from the report’s executive summary:
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