28 Mar 2008

Handling Undervalued exchange rates and Sovereign Wealth Funds under WTO: A failed solution already?

It is very recently that we picked up this paper which has been posted on SSRN for sometime now but then that we have and feeling strongly on the issue, we thought it was wise to have an exclusive post on the topic. Today we are discussing in the backdrop of a Working Paper published under aegis of Peterson Institute for International Economics and developed by two economists, entitled 'Currency Undervaluation and Sovereign Wealth Funds: A new role for the World Trade Organization', available at SSRN. Though the paper is economics based, yet has enormous significance in legal arena for it deals proposes for a legal regime for two key issues facing the policy makers across the globe currently; 'Undervalued Exchange Rates' and 'Sovereign Wealth Funds'. The way we proposed to deal with the issues is first to give a basic insight into what the paper talks about and then come up with our understanding of the issues and how they are better not regulated the way the paper proposes.
What the paper proposes?
The paper is based upon two premises; (i) that currencies are artificially undervalued by countries to lag it creates to a fair international trading regime , and (ii) the accumulation of wealth as an outcome of these undervalued exchange rates and also otherwise by such countries and their consequent establishment of Sovereign Wealth Funds. Regarding the first part, the paper cites the examples of most notably China and few more countries (like UAE, Kuwait, Saudi Arabia, Vietnam, Bahrain, all oil-exporting countries) and bases its proposal to deal with the situation under the WTO for the reason that the proper valuation of these exchange rates would provide a significant boost to international trade. Regarding the second part,

To sum up (as the paper itself suggests), the paper is comprised of three parts (i) why and hows of WTO involvement, in collaboration with IMF, in dealing with undervalued exchange rates, (ii) the whys and hows of WTO involvement in regulating SWFs, and (iii) how the placing of the issues on the trade negotiating agenda could help galvanize the Doha Round.
Our views on the proposals
It was not long back that we wrote over the direction in which the Sovereign Wealth Funds are moving and the tensions that their economic might poses to geo-political relations and also generally about the failure of the WTO to come up from the contentious issue of market access (both agricultural and non-agricultural), agricultural subsidies, services and IPR in these two parts (Part - I and Part - II). In general, we have highlighted in all of these posts over how the proposals to regulate the movement of these new instruments of trade policy (basically having a foundation in developing countries) are stimulated by the enhanced fears which these strengthening of developing countries' economies pose to the self-crumbing developed economies, most notably the United States.

For example, China's accumulation of US Dollars as its foreign exchange reserve is so massive (and continues to add significantly every day) that the mere visualization of China doing away with it would send shivers to not just the United States but the consequent fall in dollar would ensue a global economic dooms day. For so long as
China keeps these funds to itself, it is fine to all. But then the United States and the international economic community as such have to find to ensure that this continues to be so and they do not get up one fine morning to find the USD collapsing in wake of China's removal of dollar from its reserve. Plus, not just the direct exodus of dollar from China, the indirect investment of China in strategic locations is the major concern. And that China is not into philanthropy, its infusion of $5bn into Morgan Stanley (which saves a liquidity crisis at this US giant) is not just seen as an act of charity but instead the gaining of lobbying power (which MS carries with it) within the United States, and thus requiring an countering act on the part of the US to mitigate any buying of political power through such economic instruments. [For more such examples, have a look at our earlier post on Sovereign Wealth Funds] Now to deal with the proposals, let us handle each issue one by one.

Undervalued exchange rates: not a new phenomenon but an ever-green subject for economic analysis and political bickering, no doubt has tremendous implications for international trade but we have out own doubts on its management under an international institution like the WTO. This is for a number of reasons as we enumerate here;

(i) Now that the impossible trinity is already a fact taken for granted and that countries grapple with the dimensions of international capital flows (installing and managing in between their own ways for promoting/inviting capital investments within their own country), a manipulated exchange rate offers a very viable and effective medium for the host countries (especially the developing countries and emerging market economies) to boost and regulate the ways capital investments flow in their country.

(ii) The flexibility and added trade advantage an undervalued exchange rate offers is not hidden from anyone. China's notorious undervaluation of its currency (Renminbi) by fixed pegging it to USD [8.2765 Renminbi Yuan to USD as wikipedia informs] and the huge trade advantage it provided to its exports (by making them cheaper artificially) is a reminder of the fact that countries with export oriented economies can strive nicely in such pegged regimes by constantly undervaluing their exchange rates.

(iii) And then emerging nations have not forgotten the last decade's South East Asian crisis, which led to a downfall of many a south east Asian nations, for which the changing exchange rate was a major trigger. Most developing countries would like to vouchsafe against such avoidable exposure to market failures and herd-run.

Now why all are three objections are directed towards a developing country paradigm is for a reason. The reason is the proposed involvement of WTO to regulate the problem (though a problem only for the developed nations which lose out comparative advantage on account of an undervalued currency of another exporting country) is itself full of controversy, given the already hot-waters WTO is in being alleged with lacking the concerns for developing countries. Instead of rewriting what we have already written [for a fuller account, read out our two posts (Part - I) and (Part - II) pointing to the bones of contention and also this critic of WTO's report on six decades of multilaterlism] but suffice would be to point the fact that after the first concrete realization and demand by developing countries for a fair (and not just free) trading regime in Doha in 2001 (though the matter was first brought to light in Seattle in 1999), the WTO has already missed a number of deadlines and has been postponing the matter (as a matter of fact it has been postponed indefinitely now with no deadlines to come out with solution) with the last six years bringing out not even a harmonious discussion ground lest to talk of a solution.

In fact the formation of the G-110 alliance of the developing countries at the last Ministerial in Hong Kong in 2005 (the fact that no date for the next Ministerial Conference has been announced, which technically should have taken place in 2007, is an issue requiring an exclusive post altogether) is in itself indicative of the fact how closely the developing countries view and keep the issue of a fair trading regime which would not compromise their development objectives but would instead promote it and so long they find the WTO's working not in consonance with their inner goals, it seems that the tussle will continue and deadlocks remain.

In this scenario, the apt choice for the developing countries would be to ensure their internal economic stability by regulating their exchange rates at the national level rather than limit their ability at the expanse of an international institution (which no matter how sound economically, would no doubt bring in the political element, a proposition which even the WTO cannot deny) and thus face the risk of economic defacing just to ensure that world trade goes smoothly.

For these reasons, we are of the view that politically and on cost-benefit analysis, the option of subjecting the exchange rate regimes to be judged by an international institution like the WTO is a non-starter proposal given the lack of political consensus. This however does not even include the paradigm of strict reluctance on the part of the developing countries to subject themselves to a more stringent rule based regime under the WTO (as the undercurrents would bring out), considering which the proposal does not even merit scrutiny.

In this background let us compare the proposals. In a run down to the working paper in question, the authors argue "that (1) exchange rates have serious trade consequences and unlike trade interventions, which are being phased out all over the world, episodes of undervaluation are likely to recur; (2) the Fund, the natural forum for regulating exchange rates, has abdicated its responsibility and is unlikely—for political reasons and its own traditions—to be able to remedy this; (3) the WTO could possibly fill this gap by creating new rules on exchange rates to parallel those on export subsidies and import taxes; and (4) these rules—as many others on trade—could become the subject of disputes in the WTO, with the Fund providing inputs on technical matters as it has in relation to trade restrictions for BOP reasons."

To deal with each of these propositions; (1) even though exchange rate have a serious trade consequence, that does not imply that the same should be brought into WTO for WTO is not THE regime to regulate international trade. The Preamble to the Marrakesh Agreement establishing the WTO is catagorical to the effect that per se trade regulation comes later and it is the sustainable development and promotion of developmental goals of the developing countries that takes precedence. In such a scenario, a national management of exchange rates being a better device towards such goals, it is better that WTO keeps out of it; (2) the fact that the IMF has failed to regulate the issue (even though it is its strict mandate to ensure against artificial manipulation of exchange rates) does not imply that another institution should take over. The core principle on which WTO works is essentially different from the IMF and also the two perform contrastingly different roles in international paradigm. Neither is the WTO platform suited to it task nor is the WTO (being a legal and not economic regime) capable of ensuring that the tasks identified for ensuring fair valuation of exchange rates can be meted out at its venue; (3) the WTO can possibly fill the gaps for many other international institutions as well. The comparatively better performance and more relevance of the WTO compared to the UN in today's world does not imply that the WTO should take over UN as well. So the argument that WTO performs better the IMF is really a fallicious and non-starter; (4) the little handling of Balance of Payment (BOP) that the WTO has undertaken has been contentious and argued as unfair and ineffective. There has really been no improvement and work on the 1979 adopted Understanding on BOP effects on trade and with this experience, it is better that WTO does not go deeper in this potential minefield of disputes.

Sovereign Wealth Funds: The emerging new saga of national investments in international framework, a hot topic for economists, lawyers and most importantly the politicians to argue over. While IMF is already mulling over the possibility of bringing out a Model Code of Conduct or sorts to ensure transparency and non-political investing through these SWFs, nonetheless the issue remains to be contentions for the description in the first part above. [for more read our earlier post on SWFs].

Before we give out our own reasons as to why we think dealing SWFs under a WTO type regime is a non-starter, let us analyze why the paper argues in favour of such an approach. In sum the paper culls out two reasons for WTO to be the home for a multilateral agreement entailing a regulatory regime for SWFs; "Firstly, the WTO already, albeit somewhat opaquely, covers investments by SWFs in its services agreement—the General Agreement on Trade in Services (GATS). A second argument in favor of WTO regulation is its dispute settlement mechanism (as in the context of exchange rates). Consider a situation where a WTO member felt that a foreign SWF was behaving inconsistently with its obligations. Instead of taking unilateral action based on its own judgment—actions that can provoke retaliatory protection and spiral into a trade or investment war—the member would now have recourse to the WTO dispute settlement mechanism. The well-established mechanism would offer institutionalized consultation and, when necessary, impartial assessment of conformity with mutually agreed conditions."

The first argument does not hold scrutiny for the fact that GATS calls forth for a non-protectionist regime, requiring the grant of market access and non-discriminatory treatment, to say the least. Dispute such rules, it is being argued that the market-access offered by the developed countries to the service providers of developing countries is cluttered with indirect and perceived obstacles and thus whatever is provided is not sufficient. In this scenario, imposition of prior-check rules and retaliatory checks on inbound investments only for the fact that they arise from nations (being SWFs) and not independent parties, would not only incite more tension between the North and South but also cast doubts on the objectivity of the entire trading system as such.

The second argument is also non-workable given the legal system that WTO's Dispute Settlement Understanding provides. Even if the proposed rules find a place in WTO, at the most their coverage would be limited to transparency and mode of entry. It couldn't go further than that for doing so would imply searching for the motivations behind the investments made by these SWFs, a subjective task and not capable of judicial determination. In any case, it would be unwise for the developed countries to argue for a move towards bringing in multilateral rules for regulating SWFs for that would imply inability to act on their own volition, delays in retaliatory action (given the standard time frame required to be followed before a judicial determination can take place) and also given the inroads this would make in the ability of the nations to handle such affairs politically.

The paper discusses other perspectives as well (such as SWF investor protection etc.) as arguments for a multilateral trading regime on SWFs but then these are only incidental and if the main purpose is not sufficed, we doubt that countries would choose to exercise their political might for a half-efficient solution. After all the scenarios are better dealt with under an economic framework but then when it turns to geo-economics, it brings in geo-politics as well and the ten years of working of the WTO have proved just the same.

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