Exchange rate misalignment and international law.

Author:Zimmermann, Claus D.
Position:P. 423-447

History is replete with examples where states have interfered with foreign exchange markets in order to influence exchange rates. The trade conflicts between the two world wars, for instance, were fought not only via the imposition of tariffs, but also via competitive devaluations. Since then, straightforward competitive devaluations have become a rare phenomenon; contemporary scenarios, in which exchange rate policies are criticized for their potentially protectionist impact, tend to be much more sophisticated. The exchange rate policy followed by China is certainly the outstanding, yet not exclusive, example. In recent years policymakers worldwide have criticized China for maintaining an undervalued real exchange rate as part of its strategy of export-led growth. (1)

During the second half of 2010, several other states resorted to measures intended to affect exchange rates either directly or indirectly; Brazil's finance minister, Guido Mantega, was prompted to declare-in a widely noticed, yet likely exaggerated, statement-that an "international currency war" had broken out. (2) On September 15,2010, following a fifteen-year high of the Japanese yen against the U.S. dollar (USD), Japan intervened on foreign exchange markets for the first time since 2004 by selling large amounts of yen, declaring it was determined

to intervene again if necessary. (3) Several developing countries took actions aimed at resisting upward pressure on their currencies. Thailand, for example, announced a new, 15 percent withholding tax for foreign investors in its bonds, and Brazil doubled a tax on foreign purchases of its domestic debt. (4) Most notably, commentators from both outside (5) and inside (6) the United States criticized the country for pursuing a policy of weakening the USD and for driving up exchange rates in the rest of the world with its plans for a second round of quantitative easing. (7)

It is important to note from the outset that questions about exchange rate misalignment--deviations of exchange rates from their economic equilibrium levels (8)--and its potential causation by exchange rate manipulation undertaken for competitive purposes did not first arise a few years ago (specifically, in relation to China). Exchange rate misalignment has been a recurrent issue in international economic relations. In the late 1960s and early 1970s, for example, Japan and West Germany, both then still in the process of rebuilding and industrializing their economies after World War II, were criticized for maintaining the yen and deutsche mark, respectively, at artificially low levels in order to promote exports. Recent calls by U.S. politicians across the political spectrum to legislate on the issue of "currency manipulation" (9) --attacking China's exchange rate policy more or less explicitly- bring to mind the saber rattling that preceded the Plaza Accord of 1985. (10)

The key rules of international law with respect to the conduct of exchange rate policies are laid down in the Articles of Agreement of the International Monetary Fund (IMF Agreement), (11) the constitutive, 1944 treaty of the International Monetary Fund (IMF). (12) It is only since the de facto breakdown of the Bretton Woods system of fixed exchange rates in August 1971, however-followed by the inescapable rewriting of the international rules of monetary conduct via the second amendment of the IMF Agreement-that freely floating currencies have become common practice for most of the world's major economies. (13) Since then, IMF member states have been authorized to opt for any form of exchange arrangement (except pegging their currencies to gold): allowing the currency to float freely, pegging it to another currency or to a basket of currencies, adopting the currency of another country, or participating in a currency bloc, to name just the major options. (14)

In order to ensure that IMF members exercised their regained margin of maneuver in a manner that did not endanger the stability of the international monetary system, the negotiations leading up to the second amendment of the IMF Agreement also produced a set of rules, enshrined in IMF Article IV:1, intended to guide IMF members in the conduct of their respective exchange rate policies. This provision consists of a chapeau establishing a general obligation for each IMF member to collaborate with the IMF and other members, followed by a non-exhaustive catalogue of four specific obligations intended to give concrete meaning to the overarching obligation to collaborate. The entire provision reads as follows:

Recognizing that the essential purpose of the international monetary system is to provide a framework that facilitates the exchange of goods, services, and capital among countries, and that sustains sound economic growth, and that a principal objective is the continuing development of the orderly underlying conditions that are necessary for financial and economic stability, each member undertakes to collaborate with the IMF and other members to assure orderly exchange arrangements and to promote a stable system of exchange rates. In particular, each member shall:

i. endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances;

ii. seek to promote stability by fostering orderly underlying economic and financial conditions and a monetary system that does not tend to produce erratic disruptions;

iii. 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; and

iv. follow exchange policies compatible with the undertakings under [IMF Article IV:1].

The rule set forth by IMF Article IV:1(iii) has frequently led to fierce discussions on the extent to which the IMF succeeds in ensuring compliance with the key provisions of its code of conduct. The IMF has never found even a single IMF member to be in breach of Article IV:1(iii). (15) Except in the case of an abrupt, large, and overtly competitive devaluation, the process of determining whether an IMF member is manipulating its exchange rate in breach of IMF Article IV:1(iii) is not only economically complex, but also politically delicate. Article IV:1(iii) requires a showing that exchange rate manipulation has been undertaken with the intent to gain an unfair competitive advantage over other members or to prevent effective balance-of-payments adjustment. As will be discussed below, the requirement of intent renders the key provision of the IMF's code of conduct essentially inoperative.

This article examines, in the context of existing international monetary and trade law, the complex phenomena of exchange rate misalignment, in general, and of maintaining an undervalued "real exchange rate," in particular. (16) It is structured as follows. After a brief analysis of IMF Article IV:1 (in part I) and an assessment of the IMF's 2007 reform of bilateral surveillance (with its new focus on external stability) (part II), this article looks into the key scenarios of exchange rate misalignment and their economic impact in the light of international law (part III). Turning to trade law, this article examines whether maintaining an undervalued real exchange rate might amount to an export subsidy under WTO rules (part IV), assesses the key aspects of the United States' main legislative proposals for unilateral action against exchange rate manipulation (part V), and analyzes various enigmas arising from GATT Article XV, assessing their impact on the viability of a potential WTO dispute on maintaining an undervalued real exchange rate (part VI). The article concludes by commenting on the need for the international community to focus on global current account imbalances as the underlying problem (part VII).


    The four obligations contained in the non-exhaustive catalog under IMF Article IV:1 (as quoted in full, above) differ significantly concerning their respective purposes and legal impact. As analyzed by the IMF's Legal Department, (17) the first two obligations (paragraphs (i) and (ii)), which were introduced by the second amendment of the IMF Agreement, reflect "the important relationship between a member's domestic policies and its exchange rate." As signaled by their moderate language (shall "endeavor" or "seek"), "these obligations are of a particularly 'soft' nature, out of recognition that members should not have to give up a significant degree of sovereignty with respect to policies that, while they may have an international impact, are of a domestic nature." (18) In addition, both provisions are framed in vague terms (for example, "orderly economic growth with reasonable price stability") that leave plenty of room for interpretative differences. As observed by Francois Gianviti, a former director of the IMF's Legal Department and IMF general counsel between 1987 and 2004, the quasi-impossibility for the IMF to establish a breach of obligation was the side effect, or maybe even the deliberate objective, of formulating the first two obligations in IMF Article IV:1 as vague obligations of conduct rather than as precise obligations of result. (19)

    The obligations under paragraphs (i) and (ii) appear to have been included in IMF Article IV:1 out of recognition that in an open economy, no economic and financial policies are purely domestic, especially at a time of ever increasing economic globalization and financial integration. Whereas paragraphs (i) and (ii) thus enable the IMF to discuss more or less any aspect of a member's economic and financial policies with that member, IMF members retain full regulatory authority over their economic and financial policies. Any actual adjustment of those policies deemed useful by the IMF in the name...

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