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Thursday April 14, 2005 - 13:43:14 GMT

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No room for G7 complacency

At the spring meetings, G7 members are likely to stick with their recent mantra of greater exchange rate flexibility in Asia and the need to avoid destabilising exchange rate movements.

The relative exchange rate stability over the past two months is due to the action of conflicting forces on major currencies rather than an indication of an improvement in the underlying global imbalances. Indeed, these conflicting pressures are liable to intensify over the next few months, increasing the risks of market instability.

If the imbalances are not tackled this year and Asian currencies are not allowed greater flexibility, there will be a high risk of renewed exchange rate volatility and destabilising dollar moves later this year. In this context, there is certainly no room for G7 complacency over the currency-market situation.

Currency situation less urgent

G7 will spend some time discussing currencies at the spring IMF and World Bank meetings from late this week, but the situation is now more comfortable in terms of near-term currency levels and the forex markets should certainly be less of a focus than at recent G7 meetings.

After strengthening to a high beyond 1.36 against the dollar at the end of 2004, the Euro has weakened back to near 1.28. Although the Euro is still strong in historic terms, there will be relief that the dollar has avoided further destabilising losses during the first 100 days of 2005. The prime concern for the ECB and European officials will be to avoid rapid dollar depreciation as it is the pace of change that will be vital for the European exporters. Slow appreciation allows changes in relative prices to be matched with productivity growth, but rapid currency shifts cause substantial difficulties. Officials are likely to see medium-term dollar depreciation as essential in the battle to curb US external imbalances, but there will be strong opposition to rapid dollar declines.

In this context, the G7 countries are likely to repeat the message contained in previous meetings that ‘excess volatility and disorderly movements in exchange rates are undesirable for economic growth’.

There is likely to be a greater focus on the negative impact on growth of high energy and commodity prices. Oil prices will be an important focus as rising costs will widen the US trade deficit and damage European growth. There will be some relief that prices have eased back to near US$50 p/b from levels around US$58 p/b.

Japan less concerned over dollar levels

The yen has weakened back to around 108.0 against the dollar from highs beyond 102.0 seen during the first quarter. The Japanese Finance Ministry has not intervened in the currency markets this year and the Japanese authorities can have little complaint over the yen’s current level against the US currency. The overall competitive position remains comfortable for Japanese exporters.

China remains a major long-term issue

There will be further debate over the Chinese yuan, but Chinese officials will not be attending meetings and Japanese officials have stated that the subject of yuan revaluation is unlikely to be discussed in detail. There will still be calls for greater Asian currency flexibility and an implicit call for stronger currencies, particularly for the yuan. EU Finance and central bank officials together with the IMF and World Bank have all repeated that Asian currency flexibility is desirable in recent days.

From a fundamental perspective, the Euro is slightly overvalued at current levels. A stronger yuan would help ease global economic stresses. Strengthening Asian currencies in general would also ease potential upward pressure on the Euro.

The Euro-zone is also concerned over the potential inflationary impact of high energy prices, but an interest rate increase is unlikely unless there is a recovery in growth. In this context, stronger Asian currencies would make it easier for the ECB to push up interest rates without causing further damage to growth prospects.

No improvement in US trade

Although the near-term currency position is more comfortable, there are still serious underlying tensions and the greater exchange rate stability does not mean that the underlying stresses have been resolved. Indeed, the evidence of the past few weeks suggest that the imbalances are getting worse.

The US trade deficit, for example, increased to a record US$61.0bn for February with a surge in textile imports from China. The most surprising aspect of the trade report was the overall strength of underlying import demand and the US manufacturing trade balance is still deteriorating. There will be an increasing threat of US protectionism if there is no trade improvement within the next few months and there will be an increasing threat of bilateral US trade sanctions.

In this context, it is still vital that there are serious efforts to ease the US trade imbalances.

Markets stresses will continue

It is also the case that the dollar has responded to a covering of aggressive short positions rather than reflecting any great improvement in longer-term dollar confidence. At this point, the US currency is subject to the conflicting forces of higher interest rates and weak fundamentals with the battle between these conflicting pressures encouraging an uneasy equilibrium in currency markets.

There is a high risk that these conflicting forces will become more powerful over the next few months before potentially easing in 2006. The US Federal Reserve will continue to increase short-term interest rates which will reinforce favourable US interest rate differentials while there will also be a risk that the US current account deficit deteriorates further, especially if global growth slows. In this environment, if there is a sudden loss of traction on one side of the equation, there is likely to be a much bigger and potentially destabilising currency-market reaction.


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