December 2015

7 December 2015

Paris Climate Summit—Climate change and economic policy frameworks: 2°C for 2%

The 2015 United Nations Climate Change Conference kicked-off in Paris on 30 November. The objective of the conference is to achieve a binding agreement on climate change mitigating policies. Policy makers like to associate themselves with the need to combat climate change. But as long as climate change targets do not lead to a reordering of economic policy objectives and augmentations of existing economic policy frameworks, they will remain simple add-ons and most likely be subordinated to what policy makers still seem to care about most namely employment and price stability. The concern naturally is not how climate change can also lead to high quality inclusive economic growth, it is when it does not.

Climate change and employment and price stability do not need to be in conflict but they may. If the threat of climate change is as imminent, as it seems to be, than employment and price stability must rank behind climate change. This augmented quasi-Phillips curve, the outdated but somehow still widely used illustration of the trade-off between price stability and employment, assuming full employment, price stability and climate change are mutually exclusive, is what climate talks should be about. While the latter has of course been evoked by “zero-growth” advocates, the revalidation of economic policy priorities is key.

Central banks offer a good example. The presumed trade-off between employment and price stability was in many countries decided in favour of price stability. To that end central banks were given independence so that the political process could no longer unduly deter them from achieving their targets. The institutional accommodation of price stability reflected social preferences for reordering policy priorities.

Two options seem feasible: The establishment of new institutions and changes in the policy objectives of existing ones. The question of course would need to be addressed whether such institution or objective still make sense at all at the national level or should at least operate or be coordinated at the regional level. However, external shocks exist in all economic policy spheres.

A new institution, say an Environment Bureau, would be endowed with instrument independence to achieve a given target. Its instruments would comprise e.g. energy tariffs, energy usage and fines. The Bureau would report directly to Parliament and its head be appointed by the government for a fixed term of say a non-renewable 15 years. Its target, set by law, would be to ensure the average global surface temperature will not exceed 2 degree Celsius by or over a given point or range in time. If the Bureau perceives that economic policy or possibly the behaviour of individual firms or certain segments of the economy, say households, are not consistent with containing the set temperature rise, then the Bureau can take remedial actions by e.g. restricting electricity consumption, rising fuel tariffs, imposing fines for non-compliance with set environment standards, etc. If the Bureau perceives that monetary policy is too loose and/or fiscal policy too expansionary leading to too much output of the sort that threatens breaching the temperature target, the Bureau would be in a position to take significant counter-cyclical measures.

The introduction of climate change targets to existing key economic policy institutions would probably be even more effective. This could mean that e.g. the Bank of England is to substitute its current 2 percent inflation target for a 2°C warming target. It would conduct its policy such that over the long term the climate target would be achieved. It may mean that the Bank would have to raise its policy interest rate if it sees the current pace of activity—and without any other remedial measures—no longer consistent with achieving its climate target. While this would undoubtedly meet the criticism that a central bank should only have as its target what it can actually influence, there is no doubt generally that policy effectiveness is target dependent (see debate about adequacy of inflation targeting).

The idea to treat climate targets like any other economic policy target may sound rather unconventional. It is of course. But climate change itself constitutes a new dimension and will require rethinking public policy conduct and policy consistency more generally. Treating climate change outside the existing economic policy frameworks is unlikely to be effective. The Paris Climate Summit offers an important opportunity to send a strong signal that climate change now forms part of economic policy makers’ objective functions. It will only be when one hears a central bank governor say that monetary policy will have to tighten as it will otherwise lead to overheating that one knows climate change as a policy priority is for real.

Climate change—What the IMF can do

The IMF states it is not an environmental organisation.1 It acknowledges that climate change poses “worrying tail risks” and promotes carbon pricing as the “centrepiece of climate mitigation efforts.” The former suggests that the IMF fails to recognise the essence of structural risks from climate change. The latter reveals that the IMF may not take due regard of measures it itself controls and can implement immediately. By stating that it is not an environmental organisation, the IMF also insinuates that climate change is exogenous to economic policy. The Fund thus risks missing an important opportunity to make climate change an integral part of the international economic policy dialogue. Meanwhile, green GDP accounting, the IMF can do today.

Climate change is not a tail risk. The impact of the measures to prevent climate change are. Tail risks are low probability events. There is consensus that climate change without remedial measures is a high probability event and will have very grave consequences when it happens. The negative tail is that the outcome is worse and the positive tail that the outcome is more benign than thought. The negative tail risk of climate change regarding its impact on the global economy is that the measures thought to be sufficient to contain a temperature rise will be insufficient. The positive tail is that the measures will be more than enough. The key is to ensure that the negative tail of the distribution of measures taken to combat climate change is as small as possible. Unfortunately, the adverse impact of climate change on the global economy is closely distributed around the mean.

Carbon pricing is of course a sensible idea. In Lima, during the IMF World Bank Annual Meetings, IMF Managing Director Christine Lagarde was asked, during a panel discussion what she thought of the importance of green GDP accounting.2 She acknowledges that while conventional GDP may not be the right measure, she stressed that carbon pricing is the way forward. While carbon pricing may indeed be the better way, it is a measure that will entirely depend on countries’ willingness to implement it. Green GDP accounting, in contrast, could be done by the IMF itself as de facto the guardian of the United Nations system of national accounts and as such the key source for GDP related data.

GDP is the sum of all final output or income generated by an economy normally during one year. Environmental damage, e.g. the use of carbon intensive technologies to produce output or the outright destruction of the environment adds to GDP; so do remedial measures to address environmental damage. This implies that the more an economy pollutes the higher its GDP. Green GDP accounting in essence deducts environmental damage from GDP. The approach penalises carbon-intensive technologies so that remedial measures, over a given accounting period, lead to a mere restoration and not augmentation of GDP. Green GDP accounting therefore represents a potent tool to illustrate how environmental damage affects countries’ outputs. Government debt, fiscal deficits, current account deficits that are normally all measured relative to GDP, could look far worse under green GDP accounting potentially undermining expectations about economic policy sustainability. As such, it may be instrumental in shifting incentives towards adopting environmental friendly policies.

The adoption of green GDP accounting by the IMF would be straight forward. The IMF can adopt the measure at least informally or possibly formally as part of its Article IV consultations. It would show green GDP in its critical data provisions and as such foster the new standard. It could make countries adopt green GDP accounting as part of a new data dissemination standard and countries would be incentivised, possibly amid peer pressure, to subscribe similar to the IMF’s Special Data Dissemination Standard (SDDS). Countries would look second-class if they cannot adopt the new standard.

The IMF needs to take climate change more seriously. The Fund can act today by supporting a shift in economic policy incentives that favour adoption of environmentally friendly policies. Green GDP would send a powerful message that environmental destruction and output growth are mutually exclusive. The public and markets will take note. It would help elevate the climate debate into the mainstream of economic policies. The IMF has the chance to act decisively now and should not leave needed actions simply to others.

SDR decision: China’s international economic policy leadership

The IMF concluded on 30 November its quinquennial review of the Special Drawing Right (SDR) valuation. The IMF affirmed inclusion of the renminbi in the SDR currency basket. It is the first time there is a net addition of a currency to the basket. It demonstrates that China is interested in promoting the SDR and as such may mark a new beginning for the IMF’s ill-fated reserve asset. More importantly, it shows that China can lead on international monetary issues.

China proved that it is willing and capable to assume leadership at the IMF. The SDR is the first major multilateral initiative by China—previous quota adjustments at the IMF, including the pending 2010 quota reform, have been supported but not led by China. China’s engagement is long overdue and critical to assume responsibility and ownership in international monetary affairs commensurate with its economic weight. Many doubted the SDR would represent a suitable vehicle to advance China’s ambitions. However, it represents a very concrete and tangible objective and deliverable.

The SDR was visionary and meant to become a pillar of the international monetary system. At least until the late 1970s when the SDR was elevated, with the second amendment of the IMF Articles of Agreement of 1978, to become the “principal reserve asset in the international monetary system.” The IMF at the time was aiming to phase out gold as the then central anchor of the international monetary system. It was the last serious attempt to promote the SDR together with the parallel discussion of a substitution account to exchange dollars for SDRs. Both initiatives failed. The SDR languished since in oblivion until principally China revived it with a reform proposal in 2009.

The fact that China engages via the SDR is positive for the multilateral system. There has been increasing concerns that China will seek to bypass the multilateral system to promote alternative institutions like the Asian Infrastructure Investment Bank (AIIB) and foster system fragmentation. It is still a risk. However, the SDR renminbi inclusion will likely generate more interest by other countries to remain engaged within the multilateral framework.

If China is interested in the SDR, the key test though will be greater SDR issuance. There have only been three general allocations of SDRs to date and limited willingness in particular by key IMF member countries to support greater issuance. The IMF always maintained that the need is not there which however contradicts the fact that there has been considerable foreign exchange reserve accumulation since the early 2000s. There are US$285 billion SDRs outstanding compared with US$11,400 billion in foreign exchange reserves. China needs to push the IMF to rethink the conditions for SDR issuance. It may offer to have a large part of its foreign exchange reserves be swapped for SDRs via a substitution account. Unless there are more SDRs, the SDR is unlikely to be able to play a meaningful role.

China has provided a fillip to the SDR. While, the SDR basket enlargement has little direct if any effect on the market, it signals that the SDR still has life in it. China may be more ambitious regarding the SDR than simple renminbi inclusion. It may have opened a new chapter to rethink the direction of the international financial architecture. This is desperately needed. China’s G20 Presidency in 2016 may offer another opportunity to demonstrate that the international monetary system matters. The SDR may be the beginning for forming the basis to facilitate the orderly proliferation of more international currencies in the international monetary system.

Hong Kong Dollar peg revisited

The renminbi SDR inclusion may give rise to rethinking the Hong Kong dollar peg. The peg seems odd increasingly given the economic ties between China and Hong Kong. The renmimbi inclusion in the SDR basket may offer new legitimacy to the repeatedly made claim that Greater China’s currency regimes would benefit from change. A plausible outcome would be that the two other Chinese currencies, leaving Taiwan (Province of China) out for illustrative purposes, the Hong Kong dollar (HKD) and the Macau pataca (MOP), will be pegged to the renminbi (RMB). The advertisement in a restaurant in Macau illustrates this nicely (Picture):3 The conditions seem ripe for a repeg.

Hong Kong dollar Macau pataca renminbi

The Hong Kong dollar has maintained a fixed exchange rate with the dollar since June 2003 at a rate of HKD7.80 to USD1. The exchange rate is maintained through a currency board requiring that the Hong Kong dollar monetary base is at least backed 100 percent by U.S. dollar reserves held in the Exchange Fund of the Hong Kong Monetary Authority (HKMA).

The Macau pataca has been fixed to the Hong Kong dollar since 1977 and since 1983 at a rate of MOP1.03 to HKD1 (the pataca is thus indirectly linked to the dollar at MOP8 to USD1). The Monetary Authority of Macau (AMCM) maintains a currency board keeping sufficient foreign exchange to maintain a backing ratio of 100 percent.

The appreciation of the renminbi relative to the dollar implies that the Hong Kong dollar and Macau pataca have markedly depreciated relative to the renminbi. This seems inconsistent with the ambition of greater economic and financial integration in Greater China.

The idea to repeg the Hong Kong dollar and Macau pataca to the renminbi are of course not new. Economic and financial considerations are mixed given the differences in the nature of the three respective economies. The question of whether Greater China would constitute an optimum currency area is mute. Politics would trump any such consideration and to establish a formal renminbi area in Greater China seems politically very appealing.

The renminbi’s SDR inclusion does not equip the renminbi with properties needed to serve as a currency peg. However, it does serve as illustration that the renminbi has adopted a broader remit. The pataca was pegged to the Portugese escudo until 1977 and the Hong Kong dollar to the British pound until 1972. A peg to the renminbi would be affirmation that renminbi internationalisation is for real.



1 The Managing Director’s statement on the role of the Fund in addressing climate change, IMF, 25 November 2015.

2 Responding to the challenges of climate change: Conversation on climate change, 7 October 2015.

3 Tenka Standing Sushi, The Venetian, Macau