Fear key to restoring currency sanity

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The currency upheavals continue, and the fundamentals are unchanged. But in recent days there have been two new elements: the dollar weakness, previously evident against both the yen and the mark, has been principally directed against the yen; and there are at last modest signs of officialdom a-stirring. Together they make the currency outlook for the next six months just a touch clearer.

First, the news. In recent months the mark and the yen have been as one, in that they have been equally favoured in the flightfrom the dollar. Now, however, there are signs of discrimination, in that the mark has come off quite sharply while the yen has continued to rise. This divergence was particularly notable yesterday.

What is up? As usual, when the markets move in an unexpected direction there are attempts at post hoc rationalisation. The simplest explanation is that the last cut in German interest rates indicated that the Bundesbank was taking into account the effect that the rising mark was having in tightening monetary policy and would accordingly be prepared to loosen policy yet further if the mark continue to appreciate. By doing the unexpected, the Bundesbank not only wrong-footed the market in the short term. It also signalled that the mark would not move in one direction for ever and a day. The Bundesbank likes to surprise.

The Bank of Japan has not acted with similar style; it has not only failed to get ahead of the market on this occasion, but has no reputation for so doing. Indeed, rather the reverse: it has the reputation for moving only when its plans have been widely discussed and indeed widely leaked to the market. So the capacity to surprise is missing. Result: the failure to cut rates simultaneously with the Bundesbank (or very soon after) has given the impression of paralysis. Given the fact that, alone of the large economies, Japan has not recovered from recession, monetary policy in Japan is too tight already. The effect of the rising yen is to tighten it further. Yet the Bank of Japan has not shown willingness to offset that move.

There are other explanations. These include the unwillingness of Japanese financial institutions to follow their previous currency losses by investing yet more overseas, although on a two-year view this must be the right time to diversify out of yen assets. The yen's rise will also have something to do with the post-Kobe effect: the need to repatriate funds to assist not only in the rebuilding of Kobe but also "retro-fitting" many of the older buildings in the Tokyo region to make them less vulnerable to earthquakes.

But simple explanations are frequently the best, and I suspect that, for the time being at least, the fact that one monetary authority can surprise the markets and the other does not seem to be able to do so is the best rationale on offer.

Now for the response of officialdom. Nothing significant has happened so far. Indeed, the whole response has been marked by its ineffectiveness. The half-hearted attempts to steady the currency markets by intervention have been extraordinarily inept in that they have been poorly co-ordinated and not supported by key countries. The world's monetary authorities are known to disagree on the appropriate response to currency instability.

Last Friday the French finance minister called for a new common international approach on the lines of the Plaza and Louvre accords. Were it possible to assemble such an agreement, the Japanese would doubtless welcome it. But the whole ideais being quietly dismissed by other finance ministries.

In particular, the United States is still smarting from what it perceives as Japanese intransigence on trade liberalisation. Without American support no new agreement is possible.

Nevertheless, there are some small signs that the damage to the world economy of currency instability is starting to unsettle policy-makers. I picked that up on a visit to Washington at the end of last week. Concern is not yet being translated into action, nor will it necessarily be so converted by the time of the next Group of Seven finance ministers meeting later this month.

But this meeting, ahead of the half-yearly interim committee meeting at the IMF, is a sufficiently important point on the annual calendar that something will have to be said. At the very least, the ministers will need to talk about the point at which they should assemble a contingency plan to steady the markets, and what that plan might contain. They are not yet sufficiently frightened; by the end of the month they might be.

To say all this, might seem more to confuse than to clarify. But currency crises have a certain natural life to them. At some stage the divergence becomes so absurd that the markets themselves correct. The trick is to try to pick the moment where they are ready to be told the levels are absurd, and couple statements to that effect with enough of the action the markets are seeking to convince them that the turning point has been reached.

That natural turning point will occur some time during the summer. Inept action by policy-makers could delay it; skilled action could bring it forward. The swing of the dollar against the yen in the past few days has brought the markets even further into the overshoot zone; the fact that a new Louvre-style accord is openly being discussed has demonstrated that finance ministries know that something will be expected of them soon.

By the end of this year there will have been a recovery of the dollar. It may not be a very strong recovery, for there are a host of associated reasons that will ensure the currency remains undervalued on purchasing power parity for several years. These include the negative net asset position, the low US savings level, and the budget and current account deficits.

Nevertheless, a recovery there will be. The path towards that recovery, though, is far harder to chart.