Turmoil rocks the Japanese boat

Question: Is it a dollar problem or a mark problem? Answer: both.

But since the people who are most worried by the turmoil on the exchanges are neither the Americans nor the Germans, but the Japanese, do not expect an early solution. There is talk of an emergency Group of Seven meeting to discuss currencies, but a meeting that did not produce a credible mix of policies to shift investor demand would be worse than no meeting at all, just as the ill-judged intervention on the exchanges in the past few days by the central banks has done more harm than good.

To say that is not to pretend that the present situation is satisfactory. The tension between the dollar and the mark has claimed two obvious victims, the Spanish peseta and the Portuguese escudo. There will be more. The market gossip, for what it is worth, is not only suggesting that there will have to be a further devaluation of the peseta within the next few months but that the French franc will also be vulnerable as soon as the presidential elections are over.

A little added spice to this is given by the judicious placing of a story that the Spaniards had really wanted a larger devaluation, of 10 per cent, but were discouraged by fears that this might lead to even more pressure on the franc.

None of this would matter if there were a genuine long-term case for a mark revaluation or indeed a dollar devaluation. If anything the reverse is true. This year the German economy is moving into a quite serious current account deficit, which if it matches the Goldman Sachs forecast of $66bn (£41.25bn), will be almost exactly the same size in relation to GDP as that of the US. Unlike the US dollar, the mark is already overvalued on purchasing power parity so there is no cushion there. At some stage, though it seems to be taking an inordinately long time to do so, purchasing power parity will pull the mark (and for that matter the yen) down.

But none of this carries much conviction at the moment. The mood of the markets is set by a combination of emotion and interest-rate expectations. There is one rational reason why in the long term the mark should be the recipient of the "flight into quality": that it has the second largest net asset position after Japan, while the US is the world's largest debtor. But you hear very little of that in market discussion. The chatter there is all about the timing of the forthcoming German interest rate rise, or on the other side, the mismanagement by the Federal Reserve of its interest rate policy. In any case the German net asset position, while still positive, is rapidly being eroded by the persistent current account deficits since unification.

The dollar-bashing will continue because once a market trend is set, it is quite hard to engineer a turning point. Markets overshoot, but the fact that the exchanges have already overshot does not mean that they will not overshoot further. Rational discussion is not relevant: what we are seeing is a speculative excess and at times like this all that matters is market mood.

My expectation now (and by way of warning I should say I have been wrong about the dollar) is that this swing into the mark has perhaps three months to run. The climb of the mark (or the fall of the dollar) will not be a straight-line affair, for there will be pauses for regrouping on the way. But until the currencies are so far out of line that the rates have become ridiculous, the circumstances for a reversal will not be there. Concerted intervention, quite a possibility if there is a special G7 meeting to discuss currencies, will be ineffective until the markets accept that the natural turning point has been reached.

For that to happen the chief players, the US and Germany, need to be frightened about the effects of currency instability. In the case of Germany, exporters need to be priced out of markets by the high mark, and the recovery threatened. In the case of the US, the fall of the dollar needs to proceed until it starts to push up inflation to a much more serious extent than it has. At that stage the necessary mix of policies, which would include further rises in interest rates in the US, would be put in place. There may, meanwhile, have to be one of those speculative blow-offs - the time when everyone accepts that the markets are absurd but remains in thrall to them - before the turning point is reached.

What happens to the rest of the world while this happens? The country with the most serious problem is Japan, for the further the yen strengthens the greater the pressure on the Japanese corporate sector. But now a recovery of sorts is in place, the danger is perhaps less than it was even six months ago.

In Europe the climb of the mark will continue to disrupt cross-border trade as well as highlighting the cultural diversity of the Continent: some parts naturally seem to have hard currencies, others soft. Short- term interest rates in Europe will have to adjust to take this into account, just as the bond markets have acknowledged. Politicians can argue about the implications for a single currency, but that is hardly an immediate concern of investors.

And Britain? So far the pound has been reasonably well insulated, moving sharply down against the mark but climbing against the dollar, so that its trade-weighted value has remained within the 92-88 range. But it is at the bottom of that range and it is not hard to see circumstances where sterling weakness would feed through into higher inflation. The next rise in interest rates has been brought forward by the events of the past few days. The problem arises when domestic and international call for different interest rate policy. There is just enough of a case for further tightening on domestic grounds to underpin a move triggered by sterling weakness. But expect an uncomfortable few months.