March 20, 2008


The Bush Administration wants it, but can the International Monetary Fund play an important role in the struggle against Chinese currency manipulation and the fight for truly free and fair trade?

Illustrations by Matt Wood

Few issues at the intersection of economics and politics rankle U.S. manufacturers and many members of Congress more than what to do about China’s deliberately undervalued currency. Advocates of “free and fair” trade believe China has manipulated the value of the yuan to gain substantial mercantile advantage. When combined with subsidies, inexpensive labor, lax enforcement of intellectual property laws, weak environmental protection and other competitive advantages, China’s cheap yuan becomes a significant factor in growth of that nation's export economy, and the corresponding decline of many parts of the U.S. manufacturing base.

This article focuses on just one high-profile aspect of the dispute—the contention by the Bush administration that the International Monetary Fund, created in 1944 as a companion agency to the World Bank, is the appropriate agency to identify and respond to global financial disruptions caused by manipulated currencies.

There is a certain logic to the idea. Among other things, the IMF, ever since its creation, has been responsible for currency exchange surveillance. As part of the broader Bretton Woods Agreement, the IMF has had an important role safeguarding a stable global economic environment. The World Bank was charged with promoting long-term economic development and helping to eradicate poverty, both considered essential for long-term stability. The IMF was charged with safeguarding the global economic system by promoting international monetary cooperation, helping to build universally accepted payment systems, facilitating trade and making large sums of money available to member governments at risk of failing to meeting their financial obligations.

What has evolved is an agency, based in Washington, D.C., with 185 member countries and several primary activities. The IMF advises countries, especially developing nations, on economic and financial policy. It lends money to countries that can’t pay their bills, buying time so they can rebuild international reserves, stabilize their currencies and continue to import necessary goods.

Of particular interest now, however, is that third major IMF activity: surveillance of the international monetary system to identify problems that might weaken trade, disrupt the international finance system or lead to widespread economic instability.

In other words, the IMF is on the lookout for problems such as currency manipulation or, as it now more diplomatically refers to it, “fundamental exchange rate misalignment.” No wonder, then, that the Bush administration—hard pressed by Congress, domestic manufacturers and others to do something about China, yet unwilling to force the issue—sought to deflect pressure by instead suggesting, beginning in 2005, that the buck stops with the IMF. Or does it?


Most of the developed economies of the world have repeatedly called on China to permit market forces to establish the value of the yuan. In July 2005, the Chinese gave a little. China ended a rigid eight-year peg that had valued the yuan at 8.28 to the dollar. At the same time, it also revalued its currency 2.5% higher and said the yuan could trade within a daily range of 0.3%, up or down. In fact, however, the People’s Bank of China limited daily valuation changes to one-third of the maximum daily amount, or 0.1%, in effect maintaining “a managed floating exchange rate” that has been almost identical to the old peg against the dollar. Those tiny daily movements in its value served only to add to global frustration and anger with the Chinese.

So in May 2007, China made another small concession. It widened the daily trading band to 0.5% and, as fall moved into winter, actually permitted daily fluctuations in a band wider than the previous de facto 0.1%. Meanwhile, with its gross domestic product soaring ahead at double-digit rates largely because of its export success, China’s trade surplus has almost tripled since 2001 to a record $237.5 billion last year. Its foreign reserves, mostly U.S. dollars, skyrocketed to more than $1.4 trillion. Since July 2005, all those tiny daily changes have permitted the yuan to appreciate by a cumulative 12.1% against the dollar, the U.S. Treasury Department says. Its value, as of the end of February this year, was 7.15 to the dollar.

At the same time, however, the dollar’s own value has continued to fall. Normal market forces, if permitted to affect the yuan’s value, should have increased its value against the dollar substantially. Some economists now estimate that despite China’s small concessions, the yuan. is now as much as 60% undervalued against the U.S. dollar. In such an environment, what—if anything—can the IMF actually do?

There is no simple answer, even given the IMF’s baseline authority to conduct currency surveillance. In its entire history, the IMF has never cited a member country for currency manipulation. Nor has it ever used its power to invoke a “special ad hoc consultation” to even investigate suspicions. When Japan and Korea intervened massively in foreign exchange markets at various points over the past 20 years to prop up their currencies, the IMF found no foul play. “Those were normal market operations, and we don’t comment on market operations,” says IMF spokesman William Murray. “We don’t have a regulatory role.”

A significant factor in the IMF’s longstanding reluctance to strictly enforce its own rules, its critics say, can be found in an observation by Paul Volcker, the former Treasury official and Federal Reserve chairman. In the book International Economic Law, Volcker quotes “a distinguished finance minister” of a large developing country: “When the Fund consults with a poor and weak country, the country gets in line. When it consults with a big and strong country, the Fund gets in line. When big countries are in conflict, the Fund gets out of the line of fire.”

The IMF has avoided the role of currency policeman in favor of its self-described preferred role as “trusted advisor.” Part of the rationale for that stance is the reality that the institution’s original mission collapsed overnight in 1971 when President Richard Nixon stopped backing the dollar with gold. Over the next few years, a fixed exchange rate system gave way to floating exchange regimes that largely rendered the IMF irrelevant, because it transformed the specific correction of par values driven by governments into the general concept of floating rates largely determined by markets. Nevertheless, in 1977, the IMF adopted new rules on bilateral surveillance of member countries that, in retrospect, were too vague to allow it much real policy influence on international exchange rates.


Instead, beginning in the early 1980s and continuing through the 1990s, the IMF assumed a new role, serving as a “lender of last resort” in a wave of financial crises that swept through Latin America and Asia. Since 2000, as a result of criticism over its handling of the Asian and Latin American meltdowns, the nation-level loan business has practically disappeared. The IMF’s loan portfolio has plunged from $104 billion in 2003 to $11.6 billion last year, with $9 billion of that represented by a single customer, Turkey. Since loan interest was the basis for most of its revenue, the IMF now faces financial pressures of its own. So it has reinvented itself yet again, coming full circle back to monetary policy. The problem is the IMF lacks enforcement powers. Its only weapon is a popgun: its annual reports on the policies of each member country. Yet it has avoided using even that puny remedy to illuminate questionable policies of any nation, never mind economic superpowers such as Japan, South Korea or China.

Between May 1992 and July 1994, in its semiannual reports to Congress, the U.S. Treasury named China a currency manipulator five times, twice under former President George H.W. Bush and three times under President Bill Clinton. The language in the relevant section of U.S. law is not only an almost verbatim restatement of the IMF’s articles of agreement for membership, but the prescribed remedy for violation simply calls for the Treasury secretary to pursue “expedited negotiations” with the manipulator, either within the IMF or bilaterally.

But the law has a gaping loophole: “The Secretary shall not be required to initiate negotiations if the Secretary determines that such negotiations would have a serious detrimental impact on vital national economic and security interests.”

For much of the past seven years, the Bush administration’s view on China currency has been consistent. Mindful of the need to secure China’s assistance with such issues as terrorism by Islamic fundamentalists and North Korea’s nuclear program, aware of the clout of such internationally oriented companies as Wal-Mart and General Motors, the administration has always favored policies that open global markets or lower the domestic price of consumer goods, no matter the cost to domestic manufacturing. So instead of identifying China as a currency manipulator, Treasury has engaged in protracted behind-the-scenes discussions that have so far failed to produce a yuan valued in accordance with market forces.

Beginning with its May 2005 report to Congress, however, Treasury began to address China in harsher language, even though it still stopped short of making a formal finding of currency manipulation. Instead, the administration began to talk up the IMF as the solution, not modifications to U.S. trade law. Treasury turned to the IMF for action.

To prompt a more aggressive stance, in a September 23, 2005, speech, outgoing Treasury Undersecretary for International Affairs Tim Adams said, “We understand that tough exchange rate surveillance is politically difficult for the IMF. It is also true that a country has the right to determine its own exchange rate regime. Nevertheless, the perception that the IMF is asleep at the wheel on its most fundamental responsibility … is very unhealthy for the institution and the international monetary system.”

Five days later, then-IMF Managing Director Rodrigo de Rato said that, in practical terms, he could no more order China to appreciate its currency than he could demand that President Bush cut excessive spending on Social Security or Medicare. He further riled administration officials when he said the IMF saw “no evidence” that China is, in fact, a currency manipulator, based on the standard established by the IMF’s articles of agreement with member countries. De Rato said the IMF should not play the role of “umpire” of international exchange rates.

When former Goldman Sachs chairman Henry Paulson became Treasury secretary in June 2006, he renewed the pressure. “Exercising firm surveillance over members’ exchange rate policies is the core function of the institution,” he said of the IMF last April. A month later, the IMF’s Independent Evaluation Office (IEO), a watchdog entity, issued a report critical of its exchange rate surveillance between 1999 and 2005. One finding was that the IMF had failed consistently to collect the data necessary for credible analysis. The IEO also found the fund’s staff often manifested “a lack of understanding of financial markets” and “scarcity of practical experience.” The IMF was also criticized for an inability to state assessments clearly, which led to the IEO’s most important recommendation: the need for more clarity in “the rules of the game” when it comes to exchange rate policy.

No surprise, de Rato resigned last June after serving just three years of his five-year term.

The week prior to de Rato’s resignation, the IMF issued what it called a new “landmark framework for IMF surveillance” that provides “a special focus on exchange rate policies” (see “A New Surveillance Stance?”). In addition, it formally defined exchange rate manipulation in detailed language for the first time. It is now defined as either moving exchange rates—or preventing them from moving—for the purpose of exploiting a “fundamental exchange rate misalignment” to increase net exports. Furthermore, the guidelines declared that “surveillance is a collaborative process, based on dialogue and persuasion;” that effective dialogue requires “candor;” that “the IMF must be prepared to deliver clear and sometimes difficult policy messages to members and to candidly inform the international community represented by the IMF’s membership,” and that surveillance must be “evenhanded.” Finally, the guidelines say “a member should avoid exchange rate policies that result in external instability,” putting the focus on a policy’s outcome rather than its intent.

China protested. Ge Huayong, the Chinese executive director on the IMF’s 24-member board, told Xinhua news agency that “the new rules will put greater pressure on emerging-market countries, but will have little impact on developed countries. This is quite unfair.” He called for the IMF to “strengthen policy surveillance over those members who issue major reserve currencies and thus exert vital impact on the stability of [the] global system.” How do you spell “United States” in Mandarin?

The IMF, by now much battered, heeded China. On August 1, 2007, the IMF released its 2007 report on the U.S. and found the dollar was overvalued. “Further real effective dollar depreciation of 10–30% would be required to eliminate the misalignment relative to medium-term macroeconomic fundamentals,” the report said.

Then, Mark Sobel, a Treasury deputy assistant secretary, said at a Congressional hearing that “there is no reliable or precise method for estimating the proper value of an economy’s foreign exchange rate or measuring accurately a currency’s undervaluation.”

The widespread interpretation of that comment was that Treasury had undermined the IMF’s ability to do its job. Michael Mussa, who served as chief economist at the IMF from 1991 to 2001, said, “The U.S. Treasury has cut the legs from under the IMF before it even started the race. This was foolish and unnecessary, when they could have just said nothing.” Added Adam Lerrick, a professor at Carnegie Mellon University and advisor to the Joint Economic Committee of Congress, “The U.S. criticism will certainly weaken the authority of [the IMF] to comment on China’s currency. The Chinese are likely to argue that [the IMF] is wrong about their currency, too, and point out that even the U.S. doesn’t trust the Fund’s views.”


Since then, the IMF has been silent about China. In fact, its annual report on China, due last year, has been delayed. The IMF declines to comment on the report’s delay or its potential findings.

So can the IMF play a more significant role in policing currency exchange rates? “I think the IMF could play a meaningful role,” says Morris Goldstein, senior fellow at the Peterson Institute for International Economics in Washington. “But they haven’t so far. Once they had the new definition of manipulation last June, it would have made a lot of sense to start with China and provide some credibility for the new guideline. But they didn’t do anything.”

“There is a general tendency of reluctance to be in a confrontational situation with important members,” says Mussa, now a senior fellow at the Peterson Institute. “So the Fund does not as a general matter like to press these issues.”

Nevertheless, Mussa says, China is clearly practicing manipulation under IMF rules. “What the Chinese have been doing, in my judgment—and I would say in the judgment of any reasonable person—is intervening massively … to resist appreciation of the yuan in circumstances where the [Chinese] current account surplus is expanding,” he says. “That is undoubtedly manipulating the exchange rate and preventing effective balance of payments adjustment. There is just no way out of that conclusion, either under the old 1977 [rules] or the new 2007 [rules].”

At the same time, in a presidential election year with the economy at the top of the voter agenda, pressure is mounting in Congress to force China to help repair the damage its currency policy has inflicted on U.S. manufacturing. After a flurry of bills to address currency manipulation introduced in recent years in the House and Senate, almost none of which have progressed to serious debate, there is a growing bipartisan consensus that Congressional patience with China has been exhausted and action needs to be taken. A key catalyst in pushing the issue has been the China Currency Coalition (CCC), a broad-based organization supported by the Metals Service Center Institute (MSCI), as well as numerous other industry groups.

Jeff Beckington, a partner at the Washington, D.C., law firm Kelley Drye Collier Shannon, representing the CCC, says the IMF has been doing better than most people realize on this issue.

“I think the IMF has been making every effort possible,” says Beckington. “I think if the IMF were to cite China as a currency manipulator, then I think at that point, Congress might say, ‘We’ve got the blessing of the IMF,’ and pass one of the bills. I think that Treasury might feel similarly that an IMF decision along those lines would be supportive, and it would certainly put Treasury in the position of having to say publicly that it agrees or disagrees with the IMF’s assessment.” Mussa suggests a finding of manipulation might be blocked by the U.S. representative on the IMF executive board, because the administration doesn’t want to be forced to say whether it agrees with the fund.

There are indications that Treasury at last may be taking a more aggressive stance toward the IMF. In late February, David McCormick, Treasury undersecretary for international affairs, urged the IMF to make monitoring exchange rates a top priority, calling it a “fundamental responsibility” of the Fund.

Goldstein, of the Peterson Institute, says that in this high-stakes maneuvering, an IMF manipulation finding should lead to an actual policy change by the Chinese. “The IMF performing the ‘umpire’ role going forward is crucial,” he says, “because without it, you’ll never be able to maintain open markets. We’ll have protectionism and retaliation. So if you want to have open markets, you have to have an umpire that lays out internationally acceptable exchange rate policy. And when there’s a dispute between important countries, you have to be able to take it to somebody who can make a sensible, unbiased ruling. If you don’t have that, you get a free-for-all.”

“If they do their job right,” the IMF can get results despite all the obstacles, Mussa says. “If they don’t, they’ll deserve blame. Part of the problem is that none of the principal members of the IMF have been pressing on this issue, as they should have been for a number of years. But it’s time to tell the Chinese that their exchange rate policy is a real problem and needs to be adjusted.”


In June 2007, the International Monetary Fund (IMF) released its revised guidelines for currency surveillance activity. Among other things, the guidelines provide four specific principles that members must follow regarding exchange rate policies.

First, member nations must avoid currency exchange rate manipulation that would give them a mercantile advantage over other members. Second, when necessary, members should intervene in the foreign exchange markets to “avoid disorderly conditions,” i.e., short-term movements in a currency exchange rate. Next, members must take into account the interests of other member countries in their intervention policies. Finally, members must avoid exchange rate policies that result in external instability.

The IMF says it uses a number of indicators to determine whether a country’s exchange rate policies should be reviewed:

  • Prolonged large-scale intervention in the exchange market.
  • Borrowing that is unsustainable or brings exceptionally high liquidity risks, or excessive and prolonged accumulation of foreign assets.
  • The introduction, substantial intensification or prolonged maintenance of restrictions on—or incentives for—current transactions or payments.
  • The introduction or substantial modification of restrictions on—or incentives for—the inflow or outflow of capital.
  • The pursuit of monetary and other financial policies that provide abnormal encouragement or discouragement to capital flows.
  • Fundamental exchange rate misalignment.
  • Large and prolonged current account deficits or surpluses.
  • Large external sector vulnerabilities, including liquidity risks, arising from private capital flows.