Outlook: Currency instability

MERVYN KING, Governor of the Bank of England, has set himself a new challenge. Having largely succeeded in a lifetime's ambition to make domestic monetary policy predictable and boring, thus depriving columnists like me of what used to be a staple diet of surprises and cock-ups, Mr King wants to do the same to the international monetary stage, which with its vast trade imbalances and sometimes violent currency corrections, he thinks of as far too excitable for its own good.

Speaking at Gordon Brown's mini-Davos in London yesterday, Mr King drew attention to the line in The Importance of Being Earnest in which Cecily is instructed by her tutor to read her political economy. "The chapter on the fall of the rupee you may omit", she says, "It is somewhat too sensational". The travails of the currency markets were also the title of a chapter in Bernstein and Woodward's classic account of Watergate when an official stumbles into the Oval Office to say; "Mr President Sir, we have a lira crisis on our hands". The President's ineloquent reply was "F*** the lira".

The present occupant, George W Bush, seems to adopt very much the same view about the dollar and America's burgeoning budget and current account deficits. He just doesn't seem to care that the euro has appreciated by some 50 per cent against the dollar over the last three years and the yen by 20 per cent, or if he does, he's certainly not showing it. If it helps American growth, he seems positively to welcome it.

Yet others are very concerned indeed. Junichi Ujiie, chairman of the Japanese investment bank Nomura, gave this chilling analysis to the World Economic Forum in Switzerland last week. If China allows the renminbi to float against the yen this year, and it appreciates by say 10 per cent, then reasonable Japanese economic growth of 2 per cent plus is assured. If on the other hand China does nothing, the present dollar peg remains, and the yen appreciates a further 20 per cent against the dollar, then there will be no growth at all in Japan and the economy might even plunge back into recession.

So will China move to a more flexible exchange rate system any time soon, possibly by pegging to a basket of different currencies rather than just the dollar? Yes we will eventually, said Li Ruogu, deputy governor of the People's Bank of China at the same meeting, but in our own time. China will not be told when to do it, there is no timetable and the belief that Chinese intransigence is causing global trade imbalances is just plain wrong.

There is some merit in what he says. Only 10 per cent of Chinese trade is with the US, so getting rid of the peg and allowing the currency to appreciate might not have the severe effect on Chinese exports and growth everyone assumes. However, there are other distortions that are caused by the peg too. One is that it forces China to adopt the same monetary policy as the US, with very low interest rates and the economy awash with liquidity. The appropriateness of these policies for such a high growth economy are open to question. General price inflation seems to have been brought under control in China, but other symptoms of severe overheating abound. Property bubbles in Shanghai and many other cities in China make our own housing boom look like a vicar's tea party by comparison.

And what does Mr King suggest for making the international system more boring? For starters, he thinks it no longer appropriate to have the dollar as the world's only reserve currency, especially when it is so indepted. This in itself creates severe imbalances, with the Far East effectively lending America the money it needs to keep buying Asia's goods. Furthermore, G7 needs to be broadened to include non Japan Asia, in particular China and India. On both fronts there are signs that things are moving in the right direction. The G7 will eventually become the G12 - it almost was in London yesterday, with representatives from China, India, Brazil and South Africa as active as the main G7 participants - and some central banks are increasing the euro constituent of their reserves at the expense of the dollar.

But fortunately for us scribblers Mr King is still a long way from making the currency markets boring. We can expect a good few crises yet before the international system becomes as stable and predictable as domestic monetary policy.

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