For anyone not intimately in tune with the strange logic of the exchanges this must seem a curious turn of events. France, with a current account surplus, virtually no inflation, tight monetary and a tightening fiscal policy, and of course a prospective core member of the European Monetary Union, has a much weaker currency than six months ago, even though there has been no real change in the economic numbers in the interim. Britain, with strongish growth and a current account balance, with a fairly loose monetary policy and an only slowly tightening fiscal policy, and with some signs of inflation a-looming, has a much strong currency, even through there has also been no real change in the numbers. What is up?
There is a one-sentence answer, which is this. The French economy is growing slowly and needs devaluation or a sharp cut in interest rates to get it going again, while the UK economy is growing fast and sterling has become a "safe" haven from the impending euro.
The trouble with that sort of answer is that it explains what is happening, but not why. The answer to the "why?" takes a little longer. It comes in two parts. The first is fashion. The world financial community has decided that EMU might not be such a brilliant idea after all. When the plan was for an enlarged DM zone, with the French franc bound in too, that seemed a reasonable prospect. Now, whatever happens, there will be problems. The euro will embrace several weak currencies, in which case it will be unattractive, or there will be great tension between the ins and the outs. The politicians have unwittingly managed to engineer a dramatic change of mood. There is a second and more substantial explanation for the change which relies not so much on fashion as on some hard calculations about the real underlying value of currencies. As we (or rather they) have got nearer to EMU people have started to try to work out whether the present relationship between the various currencies is durable: not whether they are "right", because there is no absolutely right rate; rather whether they are near enough to be credible in the long term.
If you say you are going to lock currencies together for ever and a day, you have to be absolutely confident that you have given the choice of rate your best shot. If the choice is cobbled together by politicians late on a Sunday night (as was the lira's re-entry to the ERM) this is unlikely to impress.
So what are "reasonably right" rates? I have just come across some purchasing power parity calculations published by the US investment bank, PaineWebber. These PPP rates, developed by comparing prices in the different countries, are not necessarily the best sustainable rates for the medium term, and certainly not for the short. Actual rates are affected not just by the state economies find themselves in at any one stage of the economic cycle, but by things like the relative competitiveness of export industries and by the willingness of citizens to save. A wonderful export sector, a fairly inefficient system of local distribution and a high propensity to save explains why the yen is so high. Very efficient distribution and a lack of savings explains why the dollar tends to be weak. Nevertheless PPP rates are a useful guide to where, eventually, you might expect exchange rates to settle.
Now have a look at the table. These are not the only calculations of PPPs by any means; others have done them with rather different results. But they are useful base from which to start. The dollar under-valuation stands out, of course, being nearly 27 per cent too low against the German mark and more than 36 per cent too low against the Japanese yen. The sterling rate is not too bad - PaineWebber reckons that the PPP rate should be $1.54, about where the pound was last summer, and that now the pound is 8-9 per cent overvalued against the dollar.
Few surprises there. But now look at the rates for sterling against the mark and the franc. The PPP rate is DM3.23, which is 20 above the present rate, but higher than the central rate of sterling when it was ejected from the ERM. Against the franc, we are some 17 per cent too high: the PPP rate is about Fr10 to the pound, that useful 10-to-one ratio that made it so easy to work out the prices on the menu in a French restaurant.
Is, on this basis, the franc over-valued against the mark? Yes, a bit - a 6 per cent devaluation should set them right. But compared with some of the others on the list, the franc is not the problem: the problem is the mark/dollar rate.
Now it so happens that that is very much what monetary officials have been saying. Europe's problem is not so much an internal one of the rates between European currencies, but an external one between European currencies as a whole and the dollar. Sterling at the moment is a half-way house, being overvalued against the dollar and undervalued against the mark and the franc. Most other calculations would put the pound a bit lower - I have seen rates between DM3.10 and DM2.50 - but they would not change the general picture.
What should the conclusions be from all this for the two issues noted above: the weak franc and the strong pound? The main one, surely, is that while there may be a case a slightly lower franc, it is not a powerful one. There is on the other hand a powerful case for lower French interest rates, and if the price for that were allowing the franc to slide down a little it would make great economic sense. As for sterling you can make a decent case for the recent appreciation, and it would be tolerable for that appreciation to move a little further forward. But while there is leeway against the main continental currencies there is none against the dollar. We could sustain another 5 per cent revaluation of the exchange rate, but we are heading into unsustainable territory if we go too far beyond that.
My guess is that eventually the markets will get their way and manage to dethrone the franc and that for a while sterling will become too strong. But that is not for any scientific reason: it is simply because the exchanges always overshoot; like supertankers, once they start heading in one direction it takes a lot to turn them round.Reuse content