The Exchange Rate
Exchange rate stability was an essential element of the Bretton Woods arrangement. This objective was explicitly incorporated into the IMF Articles of Agreement, as it was also seen as crucial for guaranteeing another purpose of the IMF, ‘to facilitate the expansion and balanced growth of international trade’. The system of fixed but adjustable pegs worked well for more than a quarter of a century, with some flexibilities. All countries are essentially free to choose any exchange rate regime they prefer. The only constraint, according to the revised Article IV of the Agreement agreed in 1976, is that countries should avoid manipulating their exchange rates, in particular to gain competitive advantages.
As agreed at Bretton Woods, exchange rates are essential for their effects on international trade, and play a central role in correcting global payments imbalances. This is the basic reason why they should be under IMF jurisdiction and be part of broader mechanisms of macroeconomic policy coordination. Indeed, one of the major issues in relation to exchange rates is their ‘excess volatility’ since the North Atlantic financial crisis, including that which characterizes the most important bilateral exchange rate, the euro/dollar rate. It is unclear what purpose this high level of volatility between the world’s two most important currencies serves.
The system could therefore be improved by introducing elements that enhance the capacity of exchange rates to contribute to correcting global imbalances and to provide a reasonable level of stability, which is of course crucial for international trade.
A simple set of indicators should be used, mixing reference exchange rates with information about current account deficits, reserve levels, and global output gaps.
Capital Account Regulations
The central role that capital flows play in determining exchange rates and exchange rate volatility brings into focus an additional leg of international monetary reform: the management of the capital account. This issue links with broader concerns of financial stability, which the recent crisis placed at the centre of global cooperation.
The essential problem is that capital flows, like finance in general, are highly volatile and pro-cyclical. Furthermore, capital account volatility tends to be stronger in emerging market economies than in advanced economies (with lower-income countries being largely rationed out from private capital markets). Cyclical swings in net flows, risk spreads, and availability of long-term financing are some of the major determinants (and, under certain conditions, the major determinants) of business cycles in emerging economies.
Furthermore, given the dominant role of advanced economies in international finance, a small change in their portfolios can have major repercussions on emerging economies.
This is the principle that should apply to rules on the liberalization of capital flows of the OECD and investment rules in free trade agreements.
Capital account regulations should be seen as part of the normal toolkit of macroeconomic interventions that should be used simultaneously with other macroeconomic policies to limit excessive capital inflows and avoid domestic overheating or exchange rate overvaluation.
Furthermore, capital account regulations should be seen as a continuum, which includes macro-prudential regulations of a strictly domestic character (those that affect domestic assets and liabilities in the domestic currency), regulations that relate to the use of assets and liabilities denominated in foreign currencies in the domestic financial system, and those that regulate cross-border capital flows as such. The particular mix between these three forms of macro-prudential regulation depends on the policy objectives of the authorities and the characteristics of the domestic financial system of the countries involved.
Interestingly, this more pragmatic view is implicit in the only frame work on this issue adopted by the Group of Twenty.