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Mission IMF-Possible?

Rodrigo de Rato is seeking a bold new role for the International Monetary Fund as guardian of the global economy. His first challenge: Reduce the massive U.S. deficit with China before it triggers a crisis. It's a daunting task - some might say hopeless. Here's why he just might succeed.

Rodrigo de Rato is seeking a bold new role for the International Monetary Fund as guardian of the global economy. His first challenge: Reduce the massive U.S. deficit with China before it triggers a crisis. It's a daunting task - some might say hopeless. Here's why he just might succeed.

For an organization that at times in the 1990s seemed to run the world economy, this has been a humbling decade. The International Monetary Fund's role in promoting the so-called Washington consensus of budgetary discipline, privatization and trade liberalization provoked a strong backlash in developing countries. Asian nations, bitter about the IMF-enforced austerity measures after the region's 1997 financial crisis, have amassed record foreign exchange reserves to ensure they never again have to go cap in hand to the Fund. Argentina ignored the Fund and negotiated a debt restructuring on its own terms. In the

U.S. a congressionally mandated panel criticized IMF bailouts and urged a drastic curtailing of the organization's role.

A buoyant global economy, meanwhile, has done as much as anything to marginalize the Fund. Argentina and Brazil repaid their IMF borrowings early at the start of this year, causing the organization's lending to plummet to a 25-year low. Suddenly, it's not an idle question to ask, just what is the IMF for?

Managing director Rodrigo de Rato y Figaredo believes he has the answer. The Spaniard is determined to reassert the IMF's influence by reinventing the institution as a guardian of the global economy - a de facto successor to the increasingly outdated and unrepresentative G-7. Instead of fighting financial crises with massive bailouts, de Rato wants the Fund to try to prevent them altogether by sharpening its surveillance of member nations' economies and bringing countries together to sort out regional problems before they escalate. To launch his new strategy, he has, ambitiously, decided to tackle the biggest economic challenge on the planet today: the massive imbalances in global trade and capital flows, led by the U.S.'s huge and growing current-account deficit with China.

In a series of multilateral talks set to begin on the margins of the annual IMF/World Bank meeting in Singapore this month, de Rato and his top aides will gather together senior officials from the U.S., the 12-nation euro zone, China, Japan and Saudi Arabia to search for ways to unwind the imbalances without short-circuiting the world economy or triggering a collapse of the dollar. The broad outlines of a solution have been evident for some time - cutting the federal budget deficit and increasing private savings in the U.S., freeing up the yuan exchange rate in China, stimulating domestic demand in Europe and Japan - but domestic political constraints have prevented any meaningful policy changes. De Rato hopes that the IMF's expertise and political neutrality, combined with rising concern about the sustainability of global imbalances, can succeed in promoting reforms where years of G-7 communiquŽs have failed.

"We are close advisers of governments. We consult with them on economic policy every year," de Rato tells Institutional Investor. "That allows for global imbalances to be discussed in a framework that allows for a candid exchange of views."

The IMF boss's aim is laudable, but not a few observers wonder if he's taking on a mission impossible. Although the Fund has a crack team of macroeconomic analysts, it lacks any real influence over major nations' economic policies. Indeed, the IMF has criticized the U.S. budget deficit for years to little avail, and more recently has urged China to adopt a more flexible exchange rate system, with similar results.

"The IMF only has influence over countries that borrow from it," asserts Nor Mohamed Yakcop, economic adviser to Malaysian Prime Minister Abdullah Ahmad Badawi.

"For the Fund to remain meaningful, it has to go into multilateral surveillance," says Caio Koch-Weser, the London-based vice chairman of Deutsche Bank and a former German deputy Finance minister. He adds, however, that "the real question is whether some of the big players, primarily the U.S., will play that game."

So far the major players are participating, but - here's the rub - for purposes of their own, conflicting, agendas.

The Bush administration is supporting de Rato's initiative largely, it seems, because its own efforts at pressuring Beijing to float the yuan have failed. Timothy Adams, undersecretary of international affairs for the U.S. Treasury, says the IMF needs to return to the core mission it was given 60 years ago: monitoring countries' exchange rate policies to ensure they don't cause balance-of-payments problems. "There are rules, and we have to acknowledge when they're not being followed," Adams says, in a clear reference to China's managed exchange rate.

Chinese officials are also supporting the IMF's multilateral talks, but they contend that the onus is on the U.S. to curb its deficit. "We want to cooperate fully with the Fund and listen to any policy advice for China," says Wang Xiaoyi, a People's Bank of China official who serves as the country's executive director at the IMF. "But we encourage Fund staff to identify which among the five parties should contribute the most to reducing imbalances. Because the U.S. current-account deficit has enlarged in recent years, it basically reflects the domestic fiscal deficit and also the steady decrease in the savings rate."

Stepping into the fray, de Rato is well aware of his limits. As a former Spanish Finance minister who participated in the euro zone's failed efforts to enforce its budgetary rules a few years ago, he knows firsthand the difficulties of multilateral policymaking. But the 56-year-old lawyer is convinced that the IMF can play a useful role, and he says that preparatory talks with each of the five parties to the imbalances consultations have been positive.

"The fact that governments are willing to engage in discussions with us and with others is a sign that they accept there is an issue, and that they have a part to play in resolving the imbalances," he says. "I think that is not a bad start."

IMF officials are careful to play down the prospect that the consultations will produce dramatic results. They dismiss suggestions that the talks might lead to anything like the 1985 Plaza accord, under which the U.S., its main European allies and Japan agreed to encourage a weaker dollar and to take domestic policy measures aimed at reducing the big U.S. current-account deficit of the time. Instead they hope to start a process of small, mutually reinforcing steps by the parties to the multilateral talks.

The imbalances "don't have to be solved tomorrow," says John Lipsky, a former JPMorgan Chase & Co. economist who took over earlier this month as de Rato's first deputy managing director. But, he adds, "it is critical to bolster confidence that policies and fundamentals are moving in the right direction."

The global economic outlook has changed in ways that could make the major countries more open to coordinated policy action, economists say. Higher interest rates and a weakening housing market in the U.S. are casting doubt on the ability of indebted American consumers to keep the global economy afloat. Worries about an overheated Chinese economy are prompting Beijing to tighten administrative controls on investment and could lead officials to relax their grip on the yuan. Prime Minister Wen Jiabao said in July that Beijing would make more use of its year-old currency regime, which allows the yuan to fluctuate by as much as 0.3 percent a day against the dollar; that month the currency rose through the symbolically important level of 8.00 to the dollar, and it has appreciated by 1.7 percent against the dollar over the past 13 months - a fraction of what Washington wants, but movement all the same. Europe and Japan, meanwhile, are showing signs of more-sustainable growth, which could encourage their policymakers to take a bigger role in rebalancing global demand.

"The only time the Fund is going to be able to get things done is when the stars are aligned," says Kenneth Rogoff, a Harvard University professor of economics and public policy and a former chief economist at the IMF. "We have that now. The whole world would like to see a smooth unwinding of global imbalances."

The stakes involved in de Rato's gamble are enormous. The deficit in the U.S. current account - the broadest measure of trade in goods and services - is running at an annual rate of more than $800 billion, or 6.5 percent of gross domestic product. That's double the level at the start of the decade and an unprecedented figure for the economy of the world's reserve currency. Foreign investors and Asian central banks have financed the gap so far, but their appetite for U.S. investments isn't unlimited. Any move away from the dollar could start the currency tumbling, send U.S. interest rates climbing and undermine growth and confidence around the world. The threat of increased trade protectionism adds to the risks. The virtual collapse of the Doha round of trade liberalization has clouded the global growth outlook, and a legislative proposal in the U.S. Senate to slap tariffs on Chinese imports unless Beijing floats the yuan could trigger a trade war if enacted.

Today's volatile political and economic climate bears an eerie resemblance to the period leading up to the 1987 global stock market crash, when U.S. interest rates were rising and a widening current-account deficit prompted then-Treasury secretary James Baker III to threaten Europe and Japan with a weaker dollar, notes Nouriel Roubini, a professor of economics at New York University's Stern School of Business. Roubini served as an adviser in the Clinton administration and has worked as an economist at the IMF. "The risks that things will get out of hand and trigger a financial meltdown of the scale that was experienced in 1987 are serious," he says.

The sense of dangerous drift is accentuated by the breakdown of the Group of Seven's effectiveness as a forum for managing the global economy. The rise of the so-called BRIC economies - Brazil, Russia, India and China - has left the G-7 looking increasingly outdated and unrepresentative, even if Beijing is occasionally invited to attend. (Russia, although a full member of G-8 heads-of-government meetings, does not participate in the key meetings of G-7 finance ministers and central bankers.) And G-7 talk is rarely followed by action. The group's calls for greater exchange rate flexibility at meetings in Dubai in September 2003 and Boca Raton, Florida, in February 2004 went unheeded. At their latest meeting, in Washington in April, G-7 finance ministers and central bankers focused on the dangers of global imbalances and for the first time singled out the need for China to adjust its exchange rate, but again, it was all words, no deeds.

By sounding a big warning about imbalances but failing to take any new policy measures, the group's April communiquŽ probably contributed to the shakeout in world markets in May and June, contends Jim O'Neill, chief economist at Goldman Sachs Group in London. "It's the first time they've been so specific, and it's the first time the G-7 have failed since the Plaza accord," he says. "It tells us all there is no agreed structure about how to solve the world's problems. That's definitely part of what's unsettling markets."

The G-7's stumble presents a unique opportunity for the Fund to play a central role in finding solutions to global economic problems, says Mervyn King, governor of the Bank of England. "The IMF is the only body that can bring together the right countries," he says. "It is the only body that has universal legitimacy."

In addition to giving the Fund a new mission, de Rato is seeking to overhaul the organization's governance to give bigger quotas, or shares in the IMF's financial resources, as well as increased voting power to fast-growing emerging-markets countries and poor nations. Such changes are needed because countries like China now represent a bigger portion of the global economy than they did in 1999, when IMF quotas were last adjusted. Calls for reform are loudest in Asia, where many governments harbor grievances against the IMF for demanding austerity measures during the region's financial crisis in the late '90s. "Without reforming the governance the Fund is not entitled to advise us. The Fund loses legitimacy," says Jong Nam Oh, a South Korea executive director who represents 14 Asian and Pacific nations at the IMF.

At the Singapore meeting de Rato hopes to win agreement on a two-stage quota reform: an immediate increase for China, Mexico, South Korea and Turkey, the four countries most underrepresented at the moment, and a commitment to revise the quota formula within two years so that future adjustments can be made automatically as the world economy changes. The first part of the package should be fairly easy to settle. The U.S., Europe and Japan have signaled a willingness to cede enough of their quotas to satisfy the four countries.

Reform of the quota formula, however, promises to be far more contentious because it would affect countries' relative power far into the future. The U.S. wants a new formula based mainly on gross domestic product, which would ensure its status as the Fund's dominant shareholder, whereas Europe wants to retain the weighting that the current formula attaches to trade, which gives small European countries a relatively large share in the Fund. As a result of these disagreements, de Rato is likely to sketch out only vague guidelines for adjusting the formula at the upcoming meeting.

The managing director will have other priorities in Singapore. He is seeking consensus for a new type of contingency facility to insure emerging-markets countries against sudden outflows of capital. He also wants to tailor the organization's work in low-income countries to avoid overlap with the World Bank. But it is his plan to tackle global imbalances that will determine the Fund's relevance for the future. The job is daunting, if not impossible, but de Rato and his revamped management team are facing the challenge with vigor and a renewed sense of purpose.

IN THE FACE OF WIDENING CRITICISM from both the left and the right, the IMF has been struggling to redefine its role since the late 1990s. Many critics have argued that the Fund's advocacy of capital markets liberalization contributed to the Asian financial crisis by making countries vulnerable to outflows of speculative capital and that its demands for fiscal austerity in countries like South Korea and Indonesia worsened the recessionary fallout. In the U.S. a congressionally mandated commission chaired by Carnegie Mellon University economics professor Allan Meltzer recommended in 2000 that the IMF's mission be scaled back to providing short-term assistance to countries with payments difficulties. The commission argued that it was antidemocratic for IMF bureaucrats to impose conditions on sovereign borrowers like Mexico and South Korea and that big bailouts created moral hazard by using public money to protect private investors from losses.

The report was rejected by Clinton-era Treasury secretary Lawrence Summers, who said the proposals would gut the IMF and leave it incapable of responding to future crises. Although the Bush administration was sympathetic to Meltzer's views, it saw the Fund as a useful tool for addressing crises and backed big bailouts for Brazil and Turkey. Indeed, Fund lending hit an all-time high of $100 billion in autumn 2003. But dissatisfaction with the IMF - and its image as a tool of U.S. policy - persisted.

More recently, the Fund has faced an even more pressing, if paradoxical, challenge: Demand for its resources is drying up. The global economy is set to grow by more than 4 percent for the fourth consecutive year in 2006 - the best record since the 1970s. Emerging-markets economies have led the way, enjoying massive inflows of foreign portfolio and direct investment. This dramatic change was underscored at the start of this year when Argentina and Brazil repaid their IMF borrowings of $9.6 billion and $15.5 billion, respectively, ahead of schedule. The Fund currently has just $28 billion in loans outstanding. That's the lowest amount since the early 1980s; at just under 0.5 percent of world trade, lending is at its lowest level since the first oil price shock, in the early 1970s.

The IMF was clearly an institution in flux when de Rato took over as managing director in June 2004. Even his selection symbolized the Fund's turmoil: Developing nations, frustrated by the perennial trans-Atlantic carve-up in which Europe appointed the head of the IMF and the U.S. selected the leader of the World Bank, nominated their own candidate for the Fund, Mohamed El-Erian, a former Pacific Investment Management Co. fund manager who currently oversees Harvard University's $26 billion endowment.

De Rato prevailed thanks to solid European and U.S. support and his own track record in presiding over an economic boom in Spain. During his tenure as Finance minister and deputy prime minister, from 1996 to 2004, the Spanish economy grew by some 25 percent and generated roughly 3 million new jobs. De Rato helped fuel the boom by cutting the budget deficit, ensuring that Spain adopted the euro when it was launched in 1999 and fostering privatization and deregulation. Critics, however, accused him of keeping a heavy hand on the economy. The heads of leading privatized companies, such as Telef—nica and utility Endesa, were known in Madrid's financial circles as "friends of de Rato" for their political allegiance.

De Rato's political success was regarded by many observers in Spain as a restoration of his family's honor. De Rato comes from a wealthy entrepreneurial family in Asturias in northern Spain that had interests in textiles, construction, banking and radio. His father, Ram—n Rato Rodr’guez-San Pedro, and his brother were imprisoned in 1967 for illegally hiding capital in Switzerland; their Banco de Siero was seized by the Banco de Espa–a, the central bank.

De Rato earned a law degree from Madrid's Complutense University in 1971, followed by an MBA in 1974 from the University of California, Berkeley. He then returned to Spain, entered the family business and became active in conservative politics. His business acumen and air of authority won him a position as economic spokesman for the opposition Alianza Popular party in the early 1980s, and later in the decade he helped found its successor, the Partido Popular. When JosŽ Mar’a Aznar led the PP to victory in 1996, he named de Rato vice premier and minister of Economic Affairs, the country's Finance minister. Many conservatives regarded de Rato as a likely successor to Aznar, but the latter decided in 2003 to pass the leadership of the PP to his Interior minister, Mariano Rajoy, and pushed de Rato for the IMF post.

In de Rato's early days at the Fund, some insiders questioned his commitment to the job. While still a candidate he once described the position as "one that is impossible to do well." After moving to Washington he traveled widely in his first year but kept a low profile, prompting some European officials to wonder whether he was plotting a quick return to Spanish politics. And at a conference coinciding with the IMF's annual meeting in September 2005, the U.S. Treasury's Adams publicly admonished the Fund - and by extension its boss - for being "asleep at the wheel" in failing to confront China over its heavily managed exchange rate.

Over the past year, however, de Rato has provided stronger leadership. He focused the Fund's internal effort to redefine its role, publishing a strategy paper in September 2005 that called for an emphasis on stepped-up surveillance of member economies rather than on lending. In the following months he marshaled political support from major nations for giving the Fund a new role as global problem-solver. On the eve of the IMF's April meeting, he focused attention on global imbalances by inviting finance ministers and central bank governors of the G-7 nations and China, as well as private sector economists and fund managers, to a seminar at the Fund. The next day the G-7 and the IMF's agenda-setting International Monetary and Financial Committee endorsed de Rato's strategy.

"We were struck by how energetic he was," one senior European policymaker said of de Rato's performance. "He almost looked like a new person." Others welcomed the IMF's new effort to reduce global imbalances. "He's bold in taking these things on. He's finally showing leadership," says Deutsche Bank's Koch-Weser. Adds Angel Ubide, a Washington-based economist at Tudor Group and a former Fund economist: "The G-7 was clearly obsolete. What de Rato did was basically to kill the G-7 and create a variable geometry for solving these problems in the IMF."

De Rato has strengthened the Fund's senior management with a handful of shrewd appointments, such as JPMorgan Chase economist Lipsky, tapped to replace the departing Anne Krueger as first deputy managing director. Lipsky's financial markets background should give the Fund sharper insight into the massive private sector capital flows that drive the global economy today, observers say. "He'll get more real-time intelligence on what's happening in markets," says Robert Alan Feldman, an economist at Morgan Stanley in Tokyo and a former Fund staffer who worked under Lipsky at Salomon Brothers in the early '90s.

Lipsky sees parallels between today and 1974, when he first joined the IMF as an economist. Then, the Bretton Woods system of fixed exchange rates had recently collapsed, leading many to question the future of an organization that had been created to oversee that system. By the early 1980s, however, the Fund had transformed itself into a central player in tackling the Latin American debt crisis. "I had the good fortune to be here at one of the key points in the Fund's history," Lipsky tells II. The IMF's current attempt to mediate the problem of global imbalances is "potentially a defining moment," he adds.

Lipsky is expected to work closely with Jaime Caruana, the new head of the IMF's beefed-up capital markets and monetary systems department. The biggest department at the IMF, it has a key role to play in assessing how private capital flows affect developing economies and giving early warning about potential market risks to the global economy. Caruana was previously governor of the Bank of Spain and chairman of the Basel Committee on Banking Supervision.

Convinced that the Fund must be active in explaining its work and promoting its policy recommendations, de Rato is emphasizing communications. His recently appointed head of external relations, Masood Ahmed, is an IMF and World Bank veteran who played a key role in forging last year's G-7 agreement on debt forgiveness for poor countries as a senior official at the U.K.'s Department for International Development. "Financial crises are not gone forever, but for the next few years, financing isn't going to be the primary role of the Fund," says Ahmed. "The primary role is going to be surveillance."

Much of that surveillance will center not on developing countries, the IMF's traditional focus, but on the world's biggest economy. Thanks to a growth rate that has outpaced those of most of its leading trading partners and the outsourcing of production to China and other Asian nations, the U.S. is sucking in an ever-increasing level of imports. The country's current-account deficit has been exacerbated by the Bush administration's tax cuts, which have pushed the government budget deep into the red, and by a domestic housing boom, whose wealth effects have enabled consumers to slash savings and go on a spending spree. American household savings dipped into negative territory for the first time last year, compared with average rates of about 10 percent in the early 1980s.

Although the rest of the world bemoans American profligacy, it has been content to benefit from it. U.S. consumer demand helped spur the global recovery in 2003, fostered the torrid growth of China's export sector and offset sluggish domestic demand in Europe and Japan. What's more, the willingness of China and other Asian nations to amass unprecedented dollar reserves has sustained the deficit at levels that were once unthinkable. The U.S. current-account deficit widened to $792 billion, or 6.4 percent of GDP, in 2005, compared with $665 billion a year earlier and just $114 billion in 1995. By comparison, the deficit was $122 billion, or 2.8 percent of GDP, in 1985 when then-Treasury secretary Baker reached the Plaza accord.

"The U.S. is nowhere near not being able to service its long-term liabilities," says Raghuram Rajan, the IMF's chief economist. "But you can't run a 6 1/2 percent current-account deficit forever."

The danger is that a rapid or disorderly reduction of the U.S. deficit could trigger a global recession. Harvard economist Rogoff and Maurice Obstfeld, an economist at Berkeley, estimated in a recent paper that a halving of the U.S. deficit over two years would cause the dollar to decline by 20 to 25 percent on a trade-weighted basis. If the deficit were to fall more rapidly - say through a sharp decline in the U.S. housing market that throttles consumer spending - the dollar could drop by as much as 50 percent, hurting Asian and European economies and raising the risk of a financial crisis. "The rest of the world is not going to have an easy time adjusting to a massive dollar devaluation," the economists wrote.

Global imbalances have been debated by policymakers and academics for years, and there is broad agreement on what would solve the problem: reducing the budget deficit and increasing private savings in the U.S.; shifting from export-oriented growth to domestic demand in China and other Asian economies and allowing those countries' currencies to appreciate; and stimulating domestic growth in Europe and Japan. Getting policymakers to implement such reforms is extremely difficult, though, and therein lies de Rato's challenge.

Consider the IMF's policy recommendations to the U.S. The Fund's latest annual consultation on U.S. economic policies, published in July, advised Washington to make deficit reduction its top priority and suggested measures that included a restoration of pay-as-you-go rules requiring that any tax cuts or spending increases be funded, as well as an energy or value-added tax to raise revenues. But the Congressional Budget Office predicted last month that the federal budget deficit would fall to $260 billion in the fiscal year ending October 31, from $318 billion last year, before rising again, and the Bush administration points to the decline as evidence that its policies are working. It refuses to countenance tax hikes. "The IMF can offer their ideas about policy prescriptions, but sometimes they are divorced from the political realities," says Treasury's Adams.

As for China, the IMF's April World Economic Outlook welcomed Beijing's July 2005 decision to revalue the yuan by 2.1 percent but expressed disappointment about the currency's minimal appreciation since then. Allowing the yuan to rise would help the country shift from export-oriented growth to greater reliance on domestic demand and give authorities more leeway to use monetary policy to contain inflation. The Fund's latest consultation on China, completed this summer but not yet released, steps up calls for movement on the yuan, according to officials who have seen the report. "It shows an IMF which is very focused on China and is saying and doing the right things," says Adams.

Such comments underscore a major risk for the IMF. If the institution is perceived to be doing Washington's bidding by focusing primarily on China's exchange rate, it is less likely to persuade the State Council to take action. Wang, the Chinese IMF director, is blunt on this point. "It's not appropriate to use pressure on China," he says. Exchange rate policy "should be decided by the government itself. International pressure might have a reverse impact on their decisions."

Mindful of that concern, Washington hopes to persuade China with carrots as well as sticks. The Bush administration is supporting a big increase in China's IMF quota and voting power, but on the understanding that Beijing will allow the yuan to float more freely. That stance reflects U.S. political realities: The administration needs congressional approval of any quota reform package and can't hope to win it without movement on the exchange rate. "What we ought to say to the Chinese is, 'Let your currency float, and we'll reward you with a bigger role at the IMF,'" says Senator Charles Grassley, an Iowa Republican who is sponsoring a bill that would deny IMF quota increases to any countries with misaligned currencies.

Japan and Europe, for their part, appear eager to avoid any negative fallout on their economies from the IMF-led multilateral talks. Hiroshi Watanabe, Japan's vice minister of Finance for international affairs, says he worries that a quick appreciation of the yuan would weaken the Chinese economy in the same way the yen's appreciation slowed Japan's economy in the 1990s. He also contends that exchange rate changes alone won't correct the U.S. deficit because American companies have shifted so much of their production to low-cost countries in Asia. A dollar depreciation "would simply erode the welfare of U.S. citizens but not help U.S. industry," he says.

Xavier Musca, the French Treasury director who chairs the European Union's economic and monetary committee and will be one of the euro zone's representatives in the multilateral talks, contends that Europe has only a modest role to play in any IMF-engineered rebalancing of the world economy because its global trade is broadly balanced, notwithstanding a doubling of the EU's surplus with the U.S. over the past five years, to $112 billion in 2005. "Global imbalances are essentially an Asian-American problem," Musca tells II. "Aspirin doesn't cure the flu. We are the aspirin, not the antibiotic."

Given those well-entrenched positions, can the IMF really hope to make a breakthrough in reducing the imbalances and bolstering its authority? Fund officials are cautiously upbeat. They point out that their efforts have already helped focus greater attention on the problem.

"We have been preparing the groundwork for these discussions for some time, which is why I think there is broad agreement on what needs to be done," says economist Rajan, who led IMF staff in a preliminary round of bilateral consultations over the summer with each of the participants in the imbalances talks. The proof of success won't be a grand, Plaza-like bargain but will lie in whether the Fund can persuade countries of the domestic importance of reform. "It's not so much coordinating policies among the participants but promoting policies that are in a country's own interest," he says.

That goal is far from impossible, says Edwin Truman, a senior fellow at the Institute for International Economics in Washington and a former head of international finance at the Federal Reserve Board. Top officials at the People's Bank of China and China's Ministry of Finance realize that exchange rate flexibility would be more effective in preventing an overheating of the country's economy than official attempts to curb investment. The Bush administration could embrace pay-as-you-go budget restraints to curb the rapid growth of federal spending.

The IMF will have to make maximum use of its bully pulpit to prod the major countries into action, Truman says. So far it's not clear if de Rato is prepared to be that aggressive. Truman notes that the managing director has declined to push for a consolidation of European seats on the IMF board, which could play a significant part in a long-term reform of the organization's governance. European countries currently hold seven of 24 seats on the board, compared with one each for the U.S., Japan and China. "It's not clear whether he's really prepared to go out on a limb," Truman says of de Rato.

For now the IMF boss exudes a calm authority. The Fund is already sticking its neck out by getting in the middle of the imbalances dispute, and he is determined to see it through. "It would be a mistake if we didn't take this risk just because there is a chance we will be criticized," says de Rato.