IMF Surveillance — The 2007 Decision on Bilateral Surveillance

Under the IMF's Medium-Term Strategy (MTS), the Fund is revamping and modernizing its policies and procedures to better meet the demands of a more integrated world economy. One of the IMF's core activities is to monitor global, regional, and national economies to assess whether countries' policies are consistent not only with their own interest but also with the interest of the international community-a process known as surveillance. The IMF's work in this area is intended to help head off risks to international monetary and financial stability, and alert the institution's 185 member governments when it spots potential vulnerabilities. As part of a number of initiatives to strengthen its surveillance framework, the IMF's Executive Board approved in June 2007 a new Decision on Bilateral Surveillance, replacing its predecessor adopted thirty years ago.

Why it matters

The new Decision is the first comprehensive policy statement on surveillance, bringing more clarity about what surveillance is about and, hence, more evenhandedness and accountability. By clarifying expectations about the best practice of surveillance, it will ensure that the policy dialogue between the IMF and its member countries is more focused and more effective.

The new Decision also brings greater clarity and specificity to what exchange rate policies countries should follow and when the international community has reason to worry.

Key elements of the new Decision

The Decision on Bilateral Surveillance, adopted by the IMF's 24-member Executive Board on June 15, 2007, eliminates a significant gap in the IMF's policy arsenal by providing an up-to-date and comprehensive framework for country surveillance. The surveillance process with each of the Fund's member countries complements the IMF's oversight of the international monetary system-what is commonly termed "multilateral surveillance." [see Factsheet on Surveillance]

The Decision replaces the 1977 Decision on Surveillance over Exchange Rate Policies. Both the 1977 Decision and the 2007 Decision are designed to implement bilateral surveillance under Article IV of the IMF's Articles of Agreement, under which members of the IMF commit to a code of conduct on exchange rate policies and domestic economic and financial policies. While the IMF has a duty to monitor adherence to this code of conduct as a whole, the 1977 Decision only covered surveillance over exchange rate policies. The new Decision, by contrast, is much broader in scope.

The 2007 Decision brings together key elements of existing best practice in surveillance. It puts the concept of external stability at the center (see Box 1). The logic of Fund surveillance is that it helps foster stability in the international financial system by encouraging national policies that do not disrupt or compromise external stability. Reaffirming this logic will help minimize the risk of the IMF spreading itself too thin when carrying out its surveillance mandate.

Box 1. What is external stability?

IMF surveillance aims at fostering stability in the international monetary system by encouraging national policies that do not disrupt or compromise external stability. Here, the interest is in both the balance of payments stability of the country and the effect of its balance of payments position on the balance of payment stability of other countries.

External stability has been achieved when the balance of payments position does not, and is not likely to, give rise to disruptive adjustments in exchange rates. This requires both (i) an underlying current account (that is, the current account stripped of temporary factors, such as cyclical fluctuations, temporary shocks, and adjustment lags) broadly in equilibrium-a situation in which the country's net external asset position is evolving consistently with the economy's structure and fundamentals; and (ii) a capital and financial account that does not create risks of abrupt shifts in capital flows, whether through the presence of financing constraints or the buildup or maintenance of vulnerable external balance sheet structures.

When the underlying current account is not in equilibrium (which may be due to exchange rate policies but also to unsustainable domestic policies or to market imperfections), the exchange rate is "fundamentally misaligned." In other words, fundamental exchange rate misalignment, an important indicator of external instability under the 2007 decision, is a deviation of the real effective exchange rate from its equilibrium level-that is, the level consistent with a current account (stripped of cyclical and other temporary factors) in line with economic fundamentals.

While the concept of misalignment is clear, it is subject to significant measurement uncertainties. Accordingly, the IMF will exercise appropriate caution in reaching conclusions about misalignments. Moreover, an exchange rate would only be judged to be fundamentally misaligned if the misalignment was significant.

The new Decision also sets out the rules of the game.

surveillance is a collaborative process, based on dialogue and persuasion.
dialogue requires candor: the IMF must be prepared to deliver clear and sometimes difficult policy messages to members, and to inform candidly the international community represented by the IMF's membership.
surveillance must be evenhanded, whether countries are large or small, advanced or not, while also paying due regard to countries' specific circumstances. The latter involves, in particular, taking account of the effects of recommended policy changes on the member government's objectives besides external stability.
bilateral surveillance should be embedded in a multilateral perspective, meaning country assessments should bear in mind spillover effects from the global environment to a country and from a country's policies to the stability of the international monetary system.
surveillance should take a medium-term view.

The Decision updates the principles for the guidance of members in the conduct of their exchange rate policies. In particular, it adds a new principle, recommending that countries avoid exchange rate policies -undertaken for whatever reasons—that cause external instability. It also identifies certain developments, which, in the IMF's assessment of a member's observance of the principles, would require thorough review and might indicate the need for the Fund to initiate discussion with the member. Such circumstances would include a fundamental misalignment of the exchange rate.

Such updating was needed because the 1977 Decision did not address the developments that have most challenged the stability of the system in the past thirty years. Reflecting the period when it was drawn up, it focused on potential exchange rate manipulation undertaken for balance of payments reasons and on short-term exchange rate volatility. By contrast, the most prevalent exchange rate-related problems since 1977 have been the maintenance, for domestic reasons, of overvalued or undervalued exchange rate pegs and, more recently, capital account vulnerabilities often arising from balance sheet imbalances.

What has changed?

The 2007 Decision clarifies the roles and obligations of the Fund and its members.

a) For member countries, the Decision gives clearer guidance on how they should run their exchange rate policies, on what is acceptable to the international community, and what is not. To three existing principles (see Box 2) relating to exchange rate manipulation pursued for certain purposes and to when and how it is desirable to intervene in the foreign exchange markets, the Decision adds a fourth principle: "A member should avoid exchange rate policies that result in external instability." Moreover, an annex to the Decision elaborates on what is meant by the first (pre-existing) principle, which relates to exchange rate manipulation in order to gain an unfair competitive advantage over other members (see Box 3). While the principle on exchange rate manipulation restates an obligation of members that is set out in Article IV, the other principles are recommendations. The Decision also revises and firms up language relating to appraisal indicators (see Box 4) that could signal economic developments that would trigger a thorough review by the IMF and might indicate the need for the IMF to initiate discussion with a member about its observance of the principles Most notably, the indicators have been updated to reflect the increased importance of international capital flows.

Box 2. Four principles

The 2007 Decision outlines the following four principles for members' exchange rate policies.

A. A member shall avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.

B. A member should intervene in the exchange market if necessary to counter disorderly conditions, which may be characterized inter alia by disruptive short-term movements in the exchange rate of its currency.

C. Members should take into account in their intervention policies the interests of other members, including those of the countries in whose currencies they intervene.

D. A member should avoid exchange rate policies that result in external instability.

b) For the Fund, the Decision outlines the scope of bilateral surveillance and the basis for carrying it out. It reaffirms that surveillance should be focused on promoting countries' external stability. The Fund will examine whether a country's exchange rate and domestic economic and financial policies are consistent with this objective, implying that IMF surveillance will only look at policies that can significantly influence prospects for external stability. The Decision acknowledges that the way domestic policies contribute to external stability is by promoting domestic stability. The Decision also discusses how surveillance should be implemented over the policies of countries that are members of currency unions. Finally, it establishes clear expectations regarding elements of the best practice of surveillance—for instance, candor, evenhandedness, and attention to spillovers—which should help improve the quality of surveillance generally.

Box 3. What is currency manipulation?

The IMF's Articles of Agreement provide that member countries shall "avoid manipulating exchange rates ... to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members." But the Fund had provided little guidance on what constitutes such exchange rate manipulation. The 2007 Decision on Bilateral Surveillance that the IMF's Executive Board approved on June 15 provides guidance to the IMF's 185 member countries on the type of behavior that is at issue.

The 2007 Decision provides that a member would be "acting inconsistently with Article IV, Section 1 (iii)," if the Fund determined it was both engaging in policies that are targeted at-and actually affect-the level of the exchange rate, which could mean either causing the exchange rate to move or preventing it from moving; and doing so "for the purpose of securing fundamental exchange rate misalignment in the form of an undervalued exchange rate" in order "to increase net exports."

Box 4. Seven indicators

In its surveillance of the observance by members of the Principles in Box 2, the IMF shall consider the following developments in a country's economy as among those requiring thorough review and might indicate the need for discussion with a member:

(i) protracted large-scale intervention in one direction in the exchange market;

(ii) official or quasi-official borrowing that either is unsustainable or brings unduly high liquidity risks, or excessive and prolonged official or quasi-official accumulation of foreign assets, for balance of payments purposes;

(iii) (a) the introduction, substantial intensification, or prolonged maintenance, for balance of payments purposes, of restrictions on, or incentives for, current transactions or payments, or

(b) the introduction or substantial modification for balance of payments purposes of restrictions on, or incentives for, the inflow or outflow of capital;

(iv) the pursuit, for balance of payments purposes, of monetary and other financial policies that provide abnormal encouragement or discouragement to capital flows;

(v) fundamental exchange rate misalignment;

(vi) large and prolonged current account deficits or surpluses; and

(vii) large external sector vulnerabilities, including liquidity risks, arising from private capital flows.