The G-7 and the exchange rates

WORLD MONEY

After reading the communique issued by the Group of Seven (G-7) finance ministers last week, I was reminded of Sardar Swaran Singh, one-time foreign minister in Indira Gandhi's cabinet.

At a conference of Indian ambassadors, the participants posed a problem: the commerce ministry, they claimed, was encouraging them to promote Indian investment abroad. But when it came to releasing "precious" foreign exchange, the finance ministry was reluctant.

What should they do, they asked the minister. The seasoned sardar replied that "investment promote zaroor kariye, lekin dheeme dheeme" (promote investment by all means but gradually).

The reason to recall this anecdote is that the G-7 seems to tacitly accept, if not quite encourage, a further fall of the dollar so long as it is dheeme dheeme: there is no reference to "stability" of exchange rates. The communique did say, however, that "excess volatility and disorderly movements in exchange rates are undesirable for economic growth."

In September 2003, the G-7 finance ministers announced, "We emphasise that more flexibility in exchange rates is desirable for major countries or economic areas to promote smooth and widespread adjustments in the international financial system, based on market mechanisms."

This time around, the G-7 said that more exchange rate flexibility was desirable "for major countries or economic areas that lack such flexibility to promote...." If you compare the September statement with the latest one, the addition is the four words in italics. Clearly, the target is China.

Last time, flexibility was interpreted by the markets as a call to bring the dollar down in relation to the European currencies and the Japanese yen. Since then, the dollar has fallen, more against the euro and the pound, and somewhat less against the yen.

At the end of the latest meeting, the Japanese were prompt to claim that the call for flexibility was not aimed at Japan "" in other words, Japan would continue to intervene to arrest the yen's rise. It may be recalled that, in 2003, Japanese intervention amounted to ¥ 20 trillion ($ 190 billion).

If anything, the scale has gone up in the current year with the January intervention alone amounting to more than a third of last year's total. The scale is truly breathtaking.

No wonder, after a decade of stagnancy, the Japanese economy is in the early stages of recovery, with expected GDP growth of about 2.5 per cent for the fiscal year ending next month. Yen appreciation beyond current levels of around ¥ 105 has the potential to nip the recovery in the bud.

As for Europe, the euro's appreciation is a cause for concern for a sluggish economy with large-scale unemployment. The problem is that the responsibility for the exchange rate is diffused.

The European Central Bank (ECB) has a single-point agenda, namely, price stability, interpreted as inflation of around 2 per cent, which is where it is actually. Given the high prices of commodities, particularly oil, the ECB is probably quite happy at the helping hand to curb inflation being provided by the stronger currency.

It does not seem to be in a hurry to drop interest rates, which many have been urging. The Bank of England, actually, raised the base rate last week.

If the euro has risen sharply, if the G-7 agrees that Japan has displayed the necessary flexibility, then the trading power that needs to be flexible is clearly China, a potential member of G-7. Will it oblige, in substance and not just cosmetically?

The dollar's fall against the euro, the pound and the yen in a way exaggerates its weakness. In trade-weighted terms, the currency has fallen much less, particularly because of the dollar's strengthening against the Mexican peso, the currency of its third-largest trading partner.

Again, different indices yield different measures of the currency's long-term path. The Federal Reserve's major currency index evidences that the exchange rate is back to where it was in 1990; J P Morgan's broader trade-weighted index evidences a 60 per cent appreciation over the 1990 level (both the indices are nominal, that is, not adjusted for relative inflation).

Whatever the extent of the dollar's fall, there is consensus that it is nowhere near the level needed to bring the current account deficit down to a more sustainable level "" say, 2 per cent of GDP from the current 5 per cent.

One estimate is that, for this purpose, the rest of the world may need to grow by a third, relative to the US, increasing demand for American goods and services, and the currency also needs to fall by a similar proportion ($ 1.6 to 1 euro, ¥ 80). Of the two, the second proposition looks more realistic.

It should also be noted that, if the ECB is unwilling to cut interest rates to push domestic demand, the US authorities are no more enthusiastic about cutting the budget deficit or increasing the record low interest rates to curb domestic consumption that fuels the deficit on current account.

The budget proposal placed before the Congress earlier this month projects a fiscal deficit in excess of $ 500 billion, just about equal to the deficit on current account.

Such fiscal irresponsibility is hardly calculated to give confidence to foreign investors to bring in adequate funds to finance the deficit. Indeed, over much of 2003, the largest buyers of dollar paper were the Asian central banks.

Overall prospects? The dollar may weaken further even as John Snow blabbers about the strong dollar policy; Europe, the weakest of the big three economies, saddled with the strongest currency; and China in no hurry to upvalue the yuan.

Email: avrco@vsnl.com