Let the buck find its mark: Despite fears of panic in the bond market, Peter Torday finds few takers for official action to prop the dollar
Wednesday 06 July 1994
However, market hopes for this weekend's World Economic Summit and the central bank policy meetings that precede the Naples talks may be disappointed.
The leaders of the Group of Seven main industrial countries have never initiated official action in world markets, leaving that task to meetings of their finance ministers and central bankers. Indeed, some senior G7 officials believe the recent lull on world markets means the dollar may drop down the agenda. After falling below 98 yen for the first time since the war, the dollar currently trades close to Y99 and is below its Friday finish of DM1.5966.
President Clinton, moreover, opposes 'unusual action' to rescue the dollar, and White House officials hint that it is a yen and not a dollar crisis and therefore something for the Japanese to tackle by opening up their markets to foreign goods to cut the trade surplus.
But the issue remains of prime importance to all the government heads meeting in Naples. The collapse in bond prices has driven up long-term interest rates around the world and could slow down the broadening global recovery. The latest disruption to bond markets stemmed from the sharp slide in the dollar, and a further plunge might prove equally upsetting.
This time round, the dilemma is that the real source of instability is the bond markets. 'The problem for the G7 is that they are quite good at coming in and defending the dollar at a particular level,' said Alison Cottrell, international economist at Midland Global Markets. 'But the goal of stabilising the dollar to keep bond markets calm is more difficult to achieve.'
Nevertheless, some of the central banks may come to the dollar's aid. The Federal Open Market Committee, the US Fed's monetary policy-making arm, ends its meeting today and the Bundesbank holds its policy-making council tomorrow, and there is a growing view that US rates will be higher and German rates lower before the summer is over. There are indications, too, that the Bank of Japan is ready to cut its 1.75 per cent discount rate because the yen's rise threatens to choke its nascent economic recovery.
Swiss Bank Corp, however, urges the big three countries to hold back from a big dollar support operation. Corrective action might not work, it warns, and the cost might not be justified because it could slow US growth for some time. The markets are just beginning to recognise the growth potential of Germany and Japan, so intervention to support the dollar might simply offer speculators a one-way bet.
SBC also questions why a weak dollar should be bad for non-dollar bonds. Domestic inflation in Germany and Japan is subdued and a falling dollar curbs the impact of rising imported commodity prices. It also makes lower German rates more likely since the Bundesbank will become more relaxed about imported inflation.
SBC also believes the yen is in its final phase of appreciation, with the balance of payments surplus about to start shrinking.
'Moreover, if the German economic recovery and unification justify a firm mark, G7 central banks should certainly not resist it.'
Morgan Stanley, the US investment house, agrees this is not a dollar crisis: 'Today's seemingly dramatic shake-out is a far cry from the full-blown assaults on the greenback that occurred in the late 1970s and mid 1980s.'
Morgan argues that it is misleading to focus on the dollar exchange rate versus the mark and the yen. So far this year, the dollar has fallen by about 9 per cent against these two currencies, yet it has strengthened by 6-7 per cent against the Canadian dollar and Mexican peso. Mexico and Canada are destined to become more important US trading partners through the Nafta trading bloc. Already they account for 26 per cent of US merchandise imports, against 23 per cent for the combined imports from Germany and Japan.
Morgan points out that, on a trade-weighted basis, the dollar is down 5 per cent from its high this year - holding to the middle of a range that has prevailed since late 1987. It also dismisses fears of imported inflation on the back of a weaker dollar. 'Make no mistake about it: if the dollar's broadly based collapse of the mid-1980s didn't renew inflationary pressures, today's yen and DM-specific correction isn't about to lead to an unexpected flare-up on the price front in the cost-efficient 1990s.'
A glance at past attempts to manipulate the dollar is instructive: government efforts to respond to dollar 'crises' either work because the market has already turned, or they end in tears.
In September 1985, the Group of Five main industrial countries agreed that the relentless rise of the dollar in the early 1980s had to be reversed because it was hurting the economies of America's partners. More importantly for the free-trading Reagan administration, the surging US trade deficit was fuelling protectionist sentiment in Congress. In fact, the dollar had begun its descent in February 1985. The main central banks were thus selling dollars at a time the markets judged the US currency should decline. In working with the grain of the market, they gave the impression of success.
In 1986, the speed of the dollar's decline gave fresh cause for concern in Europe and Japan. The strategy was deliberate US policy, however, designed to stimulate other economies and narrow the American trade deficit.
In February 1987, the Group of Seven struck the Louvre Accord to stabilise the dollar and hold it within agreed ranges. But many economists now argue that this intervention helped to transfer market volatility from currencies to stocks and bonds, leading ultimately to the global market meltdown of October 1987.
Louvre had other consequences. Nigel Lawson, then UK Chancellor, exploited the agreement to derive a sterling-mark target and spent billions of dollars depressing the pound. He also cut interest rates to hold sterling to the DM3 level. The tactic helped to set off the surge in UK inflation in the late 1980s.
In the end, Louvre failed because the agreed trading ranges were arbitrary and did not necessarily amount to an anti-inflation anchor in the way the mark operated inside the European exchange rate mechanism. Shortly before the October crash, therefore, Germany was starting to raise its key short-term rates to clamp down on inflation pressures. The policy helped precipitate a public row between the US and the Bundesbank, contributing to the crash. Germany subsequently abandoned the Louvre trading ranges, the US resumed talking down the dollar, and volatility on the stock markets began to subside.
(Photographs and graphs omitted)
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