Intervention designed to catch markets off guard

By Diane Coyle

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The ideal time for central bankers to get the better of the financial markets is when the markets believe nothing is going to happen.

The ideal time for central bankers to get the better of the financial markets is when the markets believe nothing is going to happen.

That was precisely the coup engineered yesterday by the European Central Bank (ECB), the US Federal Reserve, the Central Bank of Japan and others, including the Bank of England.

The euro, having lost 28 per cent of its value against the dollar since 1 January 1999, rebounded by five percent within minutes of the central banks starting their operation to buy euros yesterday morning.

With hindsight there were plenty of clues warning of what the authorities had in mind. The ECB launched the campaign to reverse the tide of fortune for the European common currency with a small-scale solo intervention last week.

It painted a decision to sell 2.5bn euro's (£1.50bn) worth of interest earned on its dollar reserves and use the money to buy euros as a purely technical matter. But many currency market analysts were unsure whether or not to believe the explanation.

Top officials at the International Monetary Fund then took up the baton, using the launch of twice-yearly forecasts for the world economy earlier this week to call on the leading G7 countries to step in and prevent the euro declining further. The document presenting the forecasts contained a lengthy section on the dangers of allowing the single currency to remain dangerously weak.

Instead there was a risk of the under-valuation of the euro and over-valuation of the dollar could destabilise the world economy. The strong dollar has sent America's trade deficit soaring to record highs, bringing the danger of protectionism in its wake as US companies find it harder to export to Europe. What's more, as the euro had clearly fallen below any sensible level there was also a danger of a speculative reverse, triggering currency market turmoil and a dollar crisis.

The IMF report argued forcefully that only about half the decline in the new currency from its dollar launch value of $1.16 could be explained by fundamental factors such as strong US growth and the higher level of American interest rates.

Michael Mussa, the IMF chief economist, said bluntly: "The market has gone a little bit nuts." In such circumstances he said, the time came for the authorities to intervene. "If not now, when?" he added. Horst Köhler, the fund's managing director, backed him up the following day, saying: "Intervention cannot be a taboo."

It emerged yesterday that even as the IMF officials made these high-profile comments, the central banks were planning yesterday's move in an intensive series of discussions ahead of today's formal G7 meeting in Prague.

The element of surprise would be crucial in helping the intervention succeed. The currency markets were focused on whether the C7 communiqué due to be issued later today would say anything about the exchange imbalances. Few, if any, expect concrete action before the USpresidential election, arguing that a falling dollar might be an electoral liability.

"It is a major shock to the system and has had that much more of a market impact," said Jeremy Hawkins, an economist at Bank of America in London.

Analysts yesterday were undecided about whether the intervention would help support the euro in the longer-term. The involvement of the Fed certainly makes success far more likely because it means the G7 countries are presenting the market with a united front.

Sceptics believe the euro will remain inherently weak however until European governments undertake wide-ranging economic reforms and the member countries show some signs of the kind of technology-boosted growth that the USA has enjoyed.

The question of whether the dramatic action will ultimately succeed depends on whether the G7 authorities are right to think the euro's sharp downward trend had become a matter of financial market overreaction rather than economic reality.

Past joint interventions have proved successful in reversing exchange rates misalignments. The most recent occurred in April 1995, rescuing the dollar from its all-time lows, the best known examples are the Plaza and Louvre accords of the 1980s - the first of these reversed a swing which had taken the pound from $2.40 to as low as $1.03 in March 1985.

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