Joel recently mentioned a new paper by Aaditya Mattoo and Arvind Subramanian entitled "Currency Undervaluation and Sovereign Wealth Funds: A New Role for the World Trade Organization." I had been planning for a while to do a short post on it, but was distracted by other things. What interested me was the currency undervaluation part (I don't have strong opinions on sovereign wealth funds, at least not yet). As I've said before, while I am generally skeptical of expanding trade rules to cover new areas, this is one where I think trade rules would be useful.
Here is the passage from the paper where the authors explain their view of what WTO rules in the area of currency undervaluation could be:
Content of New WTO Rules
If there are plausible push and pull reasons for the WTO to regulate exchange rates, the question is how this should be done. The current provision in Article XV that “Contracting parties shall not, by exchange action, frustrate the intent of the provisions of [the WTO] Agreement …,” is too vague an obligation to provide a basis for effective regulation. Indeed, there is no jurisprudence on this provision of the GATT.
Any new rules should not be expedient and ad hoc, targeted at specific countries and tailored just to meet today’s problems. Rather they should be such that their rationale and usefulness outlive current circumstances. In terms of content, procedures, and caveats, new rules could draw upon existing ones.
First, any new rules would need to stipulate that undervalued or substantially undervalued exchange rates that stem clearly from government action act like import tariffs and export subsidies. The rule would therefore have two conditions: a clear finding of undervaluation and its demonstrable attribution to government action.
Once these two conditions are established, it would be as if GATT rules that prevent tariffs and other charges beyond previously specified ceilings and export subsidies in any form are violated.
Is it possible to make pronouncements on the issue of exchange rate misalignment with a high level of confidence? The answer is probably not, but that could be a strength rather than a weakness because the WTO would regulate only egregious cases of misalignment—where the technical determination is relatively robust and criticism-proof—demonstrably caused by government action such as intervention. The high bar would act as a disincentive to frivolous litigation on this issue.
Is it possible to attribute undervaluation to government action? Establishing this is important
because most WTO obligations relate to policy instruments themselves, but undervalued exchange rates are an outcome rather than a policy instrument. Undervaluation can result from a number of factors, including fiscal and monetary policies, policies related to capital flows, taxes and subsidies, and intervention in foreign exchange markets. A finding that a country has an undervalued exchange rate would not be justiciable unless it translates into some clear remediable policy action that a country can take to change the outcome.
In the case of undervalued exchange rates, there is a clear hierarchy of policy actions in terms of proximate causation (see Mussa 2007 for a clear discussion of this issue). Prolonged one-way intervention in foreign exchange markets by the central bank or by government and quasi-government agencies, redenomination of domestic debt into foreign currency, and extensive forward market operations are policy actions that can clearly be identified as causes of undervaluation.
The more difficult cases will involve undervaluation caused by fiscal, monetary, or trade policies. Here Mussa’s (2007) suggestions for a case-by-case determination seems the most pragmatic way forward.On the one hand, domestic objectives (full employment) will typically drive many of these policies, and the exchange rate consequences will be secondary. In these instances, countries should get the benefit of the doubt even in the event of a finding of undervaluation. But if it could be demonstrated that the mix of policies is clearly aimed at the external objective of gaining a competitive advantage, a country could then be asked to change its policy mix.
Third, who should determine whether there is undervaluation and what its policy causes are?
Recall that the IMF retains jurisdiction over exchange rates, and furthermore, technical expertise on exchange rates still resides with the IMF. Here again we draw on a precedent for joint Fund/WTO oversight over policy instruments. In the GATT, developing countries, for long, used trade restrictions for balance of payments (BOP) purposes. The assignment of responsibility in that instance was for the IMF to determine whether a country did in fact have a BOP problem, and then the WTO took over to appropriately regulate the restrictions. Indeed, two important disputes in the WTO—quantitative restrictions on beef imports by Korea (late 1980s) and on consumer goods by India (late 1990s)—involved such restrictions, which eventually had to be eliminated after dispute settlement panels found them to violate GATT/WTO rules. In the Korea beef case, the IMF determination was made in the context of the Fund’s Balance-of-Payments Committee deliberations. But in the dispute involving India, the Fund’s involvement resulted from the dispute settlement panel, in deference to Article XV requiring Fund input on these matters, posing specific questions to the Fund. Responses to these questions were treated as factual inputs, which the panel went on to interpret and use to adjudicate the case.
We envisage a procedure very similar to Fund-WTO relations on restrictions for BOP reasons. Just as in these cases, where the Fund determines whether there is a BOP problem facing countries, it would be essential for WTO panels to seek the IMF’s assessment on whether the member’s exchange rate was misaligned and whether it was a consequence of clear government action. So rather than take on the political risks of what might be very one-off and controversial pronouncements, the IMF would respond to the WTO’s request by making a more technical determination (based possibly on the results of the IMF research department’s multilateral model (CGER) for determining equilibrium exchange rates). To be sure, this determination would have to be made and approved at some high level (either the Fund’s management or the Board), but it could still be less controversial than the issue being raised within the Fund itself.
It's important to note that the authors are not concerned with all currency undervaluation, but only that which is caused by government action. In this way, their proposal for a greater WTO role is somewhat limited in scope.
I do have a question about their proposal, though, in relation to its scope. The authors seem to have a broad conception of the types of government actions that may cause undervaluation ("fiscal and monetary policies, policies related to capital flows, taxes and subsidies, and intervention in foreign exchange markets"). But are there non-protectionist reasons to take such actions? With such a wide range of policies mentioned, it seems likely the answer is yes. If that is the case, would it be a mistake to condemn all government-caused undervaluation? Do we need to look at the intent behind the particular government actions at issue? Or will governments be held liable for the impact of their policies, even if they did not intend to lessen the value of their currency?
