30/12/2008

Sterling – the € and the dollar : Iconoclaste views

In my paper dated December 5th, I drew attention to the fact that the foreign exchange market could become the next focal point of the financial crisis. The wide currency fluctuations over the past several  weeks appear to confirm this diagnosis. Sterling continues its fall to less than 3% over parity with the € at the time of writing. Simultaneously, the dollar - though still remaining within the limits of its previous fluctuations – has nevertheless been subject to swings both upwards and downwards of an amplitude that is preoccupying.

How should one interpret these phenomena ?

With regard to Sterling, the underlying  weakness of the economy has become visible at the same time as prices (in particular those of real estate) and indebtedness had reached unsustainable levels. The British stimulus plan, which received much praise when announced, is based largely on the hope of incentivising the consumer rather than investment and is accompanied by an announcement of a very significant increase in government borrowing over the next two years. It will have taken only a very short while for markets to react negatively to these indications.

Concerning the dollar, divergent and often contradictory interpretations of events have influenced the volatility of exchange rates: the strengthening of the dollar starting in July was attributed to:

-          The repatriation  of dollars resulting from the unwinding of speculative positions in commodities or the liquidation of financial assets denominated in dollars the financing of which had been subject to an excessive amount of leverage (hedge funds).

-          A growing appetite for US Treasury securities, considered as a safe haven despite the monetary policy of the Federal Reserve that reduced its official rates quasi to zero, leading to historically low rates of return which, for the 10 year Note, tested levels below 2%.

-          A feeling that the United States would be first to emerge from the economic recession.

More recently, the preoccupations of investors seem to be changing, leading to a significant fall back of the dollar compared to its best levels reached in November: 

-          The market is questionning the capacity of the Government to ensure – over time – the refinancing of the national debt as foreign investors may have less appetite and/or need their reserves for domestic purposes.

-           There is concern over the ever increasing recourse to unorthodox monetary stimulus measures such as the purchase by the Federal Reserve of securities (which equates to printing money).

-          The lack of visible impact of the exceptional measures already implemented by the Federal reserve since the summer of 2007 and by the Goverment since last September.

-          Despite a rate of inflation close to zero, a feeling is emerging that the United  States is deliberately following a policy of depreciating the value of its currency, the effects of which are beeing currently offset domestically by deflation but which on the level of foreign exchange markets is slowly being integrated into the cross rates. These are preliminary warning signales of future inflationary pressures, the effects of which will be difficult to control as soon as the fisrt signs of economic recovery appear. (I had already underscored this point in my article of June 8th “Inflation at the centre of preoccupations”).

In decyphering the situation, one should consider an additional dimension which has been widely overlooked and contains the seeds of possible damaging future confrontation. Let us recall that one of the major positive outcomes of the Washington G20 conference last November was the solemn unanimous undertaking to avoid protectionnism in the search for a solution to  the financial and economic crisis. This unanimity, deservedly praised, reflected the understanding of errors committed in the 1930’s when exacerbated protectionnism by individual countries had been a significant factor in the deepening and prolongation of the great depression. However, in a quasi deflationary environment, with interest rates broadly converging towards zero, letting one’s currency depreciate is a very effecient alternative to protectionism as it stimulates exports while discouraging imports in a much more durable way than was the case in the post war period, when, most of the time, domestic inflation had rapidly wiped out the ephemeral advantages conferred by a devaluation.

I do not believe that the solidarity among the G20 countries will survive if, through the currency markets, some of its members reap sustainable competitive advantages through a tolerated or deliberate depreciation of their currencies.

Similarly, at European level, the United Kingdom can not expect that the significant depreciation of Sterling will be tolerated beyond ceretain limits by its partners within the EU, which constitues its main export market.

It is this last consideration that encourages me to make a suggestion that justifies the word “Iconoclaste” in the heading of this paper:

In light of the quasi parity of the Pound Sterling and the Euro, would it not be possible to establish, rapidly and on an experimental basis, a “Currency Board” between Sterling and the € on a 1/1parity basis. If,over time - during which the Pound and the Euro could be used indifferently in the UK -  the experience proved conclusive, the country could then opt to join the Economic and Monetary Union.The British citizen would not be confronted immediately with the question of the “loss of sovereignty”, as it would be possible to bring an end to the experience at any time and recover full autonomy; in the interval, the British currency would remain the only “legal tender”domestically, the acceptance of the € in the UK beeing optional (the reverse being true within the eurozone).If adopted, this proposal could also avoid the possible extremely negative psychological impact that is likely to affect the British citizen, should Sterling fall below its 1/1 parity with the €.

In the mean time, the stabilisation of the cross rate would be advantageous to all parties, eliminating, as long as the system remained in force, any exchange risks associated with transactions between Britain and the Eurozone.It would afford the perfect opportunity to test, with limited risks, the reality of the advantages deriving from the inclusion of the British economy within the Eurozone and also provide the possibility of converting many eurosceptics. Among the advantages one can expect a reinforcementof the autonomy of the economy of the European Union as a whole, as an ever growing proportion of transactionswithin its borders  will be exempt of foreing exchange risk, reducing comensurately its vulnerability to fluctuations of other currencies. The political clout of Europe should also be strengthened which should be particularly welcome at a time when  the interests of all European citizens need to be defended within the framework of the negociations on the reform of the world financial system.The move should also facilitate measures to improve the “external representation” of the euro. The experience should also profit significantly the City of London which, benefitting from its superior financial infrastructure, could secure the long term preservation of its status as the preponderant financial centre of the European time zone.

Even if the parity selected is purely arbitrary, and could, in the long run, prove particularly advantageous for the British, it would be, in my opinion, a price well worth paying to ensure the linkage of the two currencies. In order to give the experience its best chances of succeeding, it would be necessary to provide for a special status, allowing the United Kingdom the opportunity to be adequately represented both at the ECB and the Eurogroup, at least as long as the Currency Board was operational.

On the eve of 2009, which should prove to be a key year for the future of Europe, you will, I hope, forgive me for succombing briefly to “dreams”’ whose only purpose is the reinforcement of the European Union which has served us all so well over the last half century.

 

22:12 Écrit par Paul N. Goldschmidt 13 Ave. Victoria 1000 Bruxelles dans Général | Lien permanent | Commentaires (0) |  Facebook |

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