Commentary: Between the dollar and the French

The spotlight on the currency market moved today from the collapsing dollar to the waning prospects for European economic and monetary union. Three French opinion polls all showed results within spitting distance of each other: two with small majorities in favour of the Maastricht treaty, and one against. The markets duly pushed up the German mark again, leaving sterling struggling only a hair's breadth away from its DM2.7780 permitted floor in the exchange rate mechanism. Whether the mark is rising because of capital flows out of the US or because of capital flows from the rest of Europe, the result is painfully the same. The threat of a UK interest rate rise is not yet off the agenda.

The markets' calculation is simply that a French 'non' in the 20 September referendum would in effect scupper monetary union. The traditionally weak currency countries within the ERM would have less incentive to lock their exchange rates to the German mark, or to get their inflation and budget deficits down. If a devaluation of some or all of the lira, peseta and pound appears more likely, then it is rational of the markets both to mark the currencies down now and to insist on a higher interest rate as a risk premium against capital losses.

All the results shown in yesterday's polls were within the 3 percentage point margin of error for their sample size, so that the result is probably now too close to call. True, the recent British election illustrates how the opinion polls can be wildly wrong. But a rational investor in the market must now rate the chances of a rejection at somewhere between a third and a half, and that risk must be priced into the value of Europe's currencies.

The Chancellor's hopes of avoiding an interest rate rise of one percentage point or perhaps two if the French reject Maastricht (and he decides to stick within the ERM) are probably negligible, but it remains sensible for him to avoid a rise beforehand if he can. After all, this squall may disappear as quickly as it came. Much is likely to hinge on the behaviour of the dollar. Although the US currency was on the sidelines yesterday, it remains a potently disruptive force in Europe's monetary arrangements. Capital flight from dollars to marks almost always leaves other European currencies scrabbling to keep up with the German unit.

The sharp collapse of the dollar also reduces the flows of profits from North America to British companies, and increases the competitive pressure from US rivals on both sides of the Atlantic, as View from City Road explains. The upside is that the dollar's fall further reduces inflationary pressure, because raw materials are usually priced in dollars and their prices take time to react to any drop in the value of their numeraire. But all of these effects will prove to be strictly temporary if the dollar does a bungee jump. It is therefore a key question as to whether the US currency has become genuinely undervalued.

One way of assessing a reasonable level for a currency is to look at that exchange rate that would broadly equate the prices of an average basket of goods in the country concerned and in the rest of the world - the so-called purchasing power parity. Updating the OECD's herculean work on international price data, Goldman Sachs calculates that the PPP for the pound against the dollar would be dollars 1.34 rather than dollars 1.99. In other words, the dollar is undervalued by 30 per cent. No wonder New York is an English shoppers' paradise.

Another way of assessing the fundamental value of a currency is to look at the FEER - fundamental equilibrium exchange rate. This is the concept developed by John Williamson from the work formerly used by the International Monetary Fund to assess the performance of currencies under the old Bretton Woods fixed exchange rate system. It attempts to calculate what exchange rate would be needed to balance both the external trade accounts with long-term capital flows, and to ensure full employment at home. On this basis, the National Institute of Economic and Social Research calculates that the dollar is a mere 5-10 per cent too low.

The difficulty for the Chancellor - and for investors - is that currencies can overshoot such fundamental values wildly either up or down. After all, the dollar soared so far in 1985 that it was almost equal to the pound. It then collapsed to dollars 1.90 in 1988, rebounded to dollars 1.55 in 1989, and hit dollars 2 in 1991. With the markets focusing on the low US interest rates compared with Germany, the dollar could have a way to drop yet.