Dollar slides to bottom of the agenda
Sunday 23 April 1995
As far as the dollar is concerned There has been a stand-off for the last couple of days, as the markets wait to see if anything much will emerge from the meetings. It is widely assumed that there will be nothing beyond some statement to the effect that the ministers believe that currency instability is A Bad Thing, plus, perhaps, some assertion that the decline of the dollar has gone too far. It is unlikely that this will satisfy the markets.
Finance ministers and central bankers retain a capacity to surprise, but this does not feel like one of those occasions when they will do so. To get positive action rather than hot air from a G7 meeting, there has to be a coalition between the three countries that matter most. The G7 comprises what on official figures are the seven largest economies in the world - the US, Japan, Germany, France, Italy, the UK and Canada. China ought by rights to be in there somewhere, but as so often, the politics lags behind the economics. Of those seven, only the first three really matter - for unless they perceive an identity of interest, nothing happens.
At the moment, no such identity exists. The US would quite like to see some recovery in the dollar, but it is much more concerned about the need to engineer a gentle end to its period of very rapid growth and is concerned about the possibility of recession. Japan would very much like to see the yen recover, but is not prepared, or maybe even able, to close its current-account surplus by sharply increasing imports. And Germany, while slightly concerned about the strength of the mark, is utterly determined not to do anything that might lead to a reawakening of inflationary forces.
Whether these positions are intellectually right or wrong is irrelevant to the harsh practical matter of what is going to happen. The G7 can be a very effective custodian of international financial stability: it stepped in and halted the rise of the dollar in 1985 with the Plaza Accord, and it stabilised exchange rates in 1987 with the Louvre Agreement. But it is hard to see this as such a time.
From the perspective of the financial markets there are two obvious questions. What will happen on the exchanges? And what are the practical consequences for other markets?
Assume the exchanges will be disappointed by whatever comes out of Washington. Assume that, maybe not immediately but at some stage in the next couple of weeks, the dollar's decline will resume. The issue then will be at what stage the markets believe they have finally driven the dollar too low, that the levels are unsustainable.
A typical scenario would be one of those market "blow-offs", where the currency suddenly moves to what is clearly an absurd level. That could be a dollar/yen rate of Y75. Everyone would then recognise that this particular game was over and that money could be made by backing the currencies the other way round. Such a turn could be supported by a rise in US interest rates (which might be justified for purely domestic reasons anyway) and naturally by central bank intervention on the exchanges. This is by no means the only possible outcome, but it is a perfectly plausible one. Timing? Before the end of the summer.
If something like that happens on the exchanges, what will be the consequences for other markets? It is simplest to focus just on equities, for there does seem to be a clear link between the very different performance of the US and Japanese currencies and the equally different performance of their share markets.
This story is told in the graphs. The Dow-Jones index last week hit new highs, while the Nikkei-Dow languished around its five-year low. Or so it would seem if you take the figures published in the press. If, however, you allow for differential currency movements a rather different picture emerges. Datastream rebased the Dow five years ago and has shown what would have happened to it in yen terms. Far from rising, it merely goes sideways. So if you were a Japanese investor and you had put money into Wall Street you would only have been square on your investment.
Much the same applies to the Nikkei. In yen terms, the performance of Japanese shares has been catastrophic over the last five years, but in dollar terms, it has merely been flat. If young Mr Leeson had made his punt on the Nikkei index in dollars instead of yen, Barings might still be alive, for the rise of the yen against the dollar would have compensated for the fall in the index.
It would be nice to be able to build a solid argument from this; to say, for example, that equity markets instinctively compensate for currency movements to deliver "fair" value. Alas, markets are rarely so wise, and the influences on share prices are much wider than the movements of the domestic currency.
But the divergent movement is sufficiently remarkable to raise this possibility. Perhaps the turn of the dollar, when it comes, will also signal the end of the bull market on Wall Street? And the turn of the yen, when it comes, will signal a revival of share prices in Tokyo?
There would certainly be rational reasons to expect a recovery in Japanese security prices were the yen to weaken, for one of the forces depressing prices is that the overly strong yen is making the export sector deeply uncompetitive and is delaying the economic recovery of the domestic market. So that half of the equation might fit. Whether the other half does seems less likely: US investors do not regard the movement of the currency against the yen as a prime motive for plunging into Wall Street. But perhaps another rise in US interest rates and further signs of the economy slowing would turn the market.
At any rate, the phenomenon is sufficiently striking to raise some questions for the British. Sterling has been behaving as a surrogate for the dollar in the last few months, sticking close to the $1.60 level, though the London stock market has failed to emulate New York's and soar to new heights. The practical question for the Chancellor and the Governor that will follow the Washington meetings will be what to do with UK interest rates. There is a rise of at least another half a percentage point to come in this cycle, but it may be delayed until the autumn. Were sterling to be dragged down along with the dollar in a summer crisis, though, the rise might be needed earlier. But since the London equity market has not risen as far and as fast as Wall Street, it should be better protected if US share prices fall.
There remains one further possibility. This is that the Washington meetings will put together a credible package of measures, including further cuts in German and Japanese interest rates, a rise in US rates to help boost savings, and a real determination by the US and Japanese authorities to correct the trade imbalance between the two countries. If that happened, everyone would win. Just sometimes the policy-makers do the right thing - but do not hold your breath this time.
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