Jeremy Warner's Outlook: World currency system at breaking point
Published: 31 October 2007
Currencies were bouncing around all over the place yesterday as traders placed their bets on what the Fed might do to US interest rates after today's meeting of the Open Markets Committee. For sterling, there is an equally important meeting next week of the Bank of England's Monetary Policy Committee. A speech by Kate Barker, one of the MPC's "floating" voters, seemed to suggest that, contrary to expectations, the Bank was quite happy to leave British rates on hold for now. Similar speculation surrounds the Fed decision, with policy-makers said to be unconvinced by the need for a further, immediate, cut in interest rates. This despite more grim housing market data yesterday. Yet whatever the opportunity for interest rate arbitrage, the big picture in currency markets remains the same as it has been for some while now, with the dollar in apparent freefall and other developed market currencies strongly appreciating. These adjustments are to some extent justified as a natural reaction to the problems of the US economy, with its humongous twin budget and current-account deficits and fast-slowing growth rate. Yet there is another dimension to all this, which is proving very uncomfortable for Europeans as their currencies continue to appreciate against the dollar. A number of currencies remain effectively pegged to the greenback, creating major distortions in the usually corrective pricing mechanisms of the free-market system. The most important of these are the Chinese renminbi, and to a lesser extent the currencies of the oil-rich Gulf states. Until quite recently, these pegs hardly mattered. The Chinese economy was too small to be of significance, while the fact that oil is priced in dollars made it natural for the Gulf states to have currencies that mirrored the behaviour of the dollar. The situation today is completely different. China is now one of the world's biggest economies, and in the next 20 years is destined to eclipse even the US. The high oil price has meanwhile hugely swollen capital flows coming out of the Middle East. America's biggest trading partners are these countries, yet there is no effective currency adjustment mechanism for addressing the imbalances that have built up between them. The result is that those currencies that do obey the laws of the free market are disproportionately punished with exceptional appreciation. To put it another way, it is the Europeans who are being forced to pay the price of America's burgeoning trade deficit with China. To make matters worse, China doesn't even sit at the high tables of the international organisations that are meant to address these issues – the G7 and IMF. It suits China to opt out. This makes their deliberations and pronouncements increasingly irrelevant. The global currency system has become as much of a mess as it was when the Bretton Woods Accord of fixed exchange rates began to break down from the late 1960s onwards, perhaps worse still. The late Herb Stein, President Nixon's economic adviser, once remarked that if something cannot go on forever, it will stop. But as ever, the question about the present bipartite system of exchange rates is when? Even within China, the pressures to allow a faster rate of appreciation against the greenback are becoming intense. Interest rates are rising in China, but falling in the US, making defence of present exchange rates tougher still. As it is, the Chinese authorities face massive portfolio losses on the dollar assets they have bought in defence of the trade surplus with the US. China wants to move at its own pace, with a gentle deflation of present pressures. The danger for the world economy is of a much more explosive resolution.
(20min delay)