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G7: Can FX markets be stabilised over the weekend?

Mon, Apr 7 2008, 14:28 GMT
by John Hydeskov

Danske Bank A/S

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G7.s finance ministers and central bank governors will gather at the International Monetary Fund / World Bank Spring meeting on 12-13 April, only two months after they gathered in Tokyo. That meeting.s conclu-sion was that despite the ongoing market turmoil, the outlook for the global economy was robust. Regard-ing the currency markets, the central message was that China had to do more to increase the flexibility of CNY and to allow for a further appreciation of its currency. Attention is now centred on the recent sharp exchange rate movements that are regarded as undesirable for economic growth. Can the G7 finance min-isters and central bank governors stabilise FX markets and what are the most likely outcomes of the forthcoming meeting? We present our views below:

• Since the last meeting, the USD has dropped 7.5% vis-à-vis EUR while the JPY has depreciated 3.7%. The CNY has lost 5% against EUR and has . in other words . only appreciated versus the USD. Historical and implied volatility has remained at elevated levels. This clearly represents a challenge for the G7.

• The G7 countries can decide to intervene in foreign exchange markets. If the exchange rate lev-els do not reflect economic fundamentals or if recent market movements have been so extreme that they have to be dampened, the G7 countries may take concerted action, implying that they will actively intervene in foreign exchange markets to support/weaken one or several currencies. The last time this happened was in 2000 to aid a very weak EUR. In 1985, 1987 and 1995 G7 countries also joined forces.

• However, the G7 countries do not always have to intervene physically. Verbal intervention can also be quite useful. The countries can express their views individually, but it has a stronger effect when the G7 backs a joint statement. After the meeting, a statement is presented and a single paragraph normally deals with exchange rates. The rhetoric of recent years' comments has not been particularly sharp or harsh, and focus has primarily been on China's reluctance to allow the CNY to appreciate fast enough.

• Our FX Crossroads from 19 March discussed the risk of intervention. The conclusion was that no central bank is currently interested in intervening, although several of the major currencies do not exactly reflect economic fundamentals. Basically, we therefore do not expect any unilateral or concerted intervention from the G7 group at current levels. This is also confirmed by surveys, according to which only 10% expect the G7 to signal an intention to intervene. In relative terms, however, unilateral intervention by a single central bank, eg, the Bank of Japan, is more likely than concerted intervention by the G7.

We believe that the verbal intervention will centre on the increased volatility, which is regarded as unwelcome and detrimental to economic growth. The French finance minister, Christine La-garde, put it very clearly when asked about her view on the foreign exchange markets on 4 April: .No volatility.. Her wish for more limited fluctuations in the foreign exchange markets is probably widely shared, but the question is whether the G7 can add stability to the markets? The simple answer is: .No, not immediately.. The volatility characterising foreign exchange markets at first stemmed from the credit markets and most recently from the equity markets. Foreign exchange markets are not per se the source of volatility, and therefore stability cannot be restored through intervention. Volatility will subside when the credit markets recover and nervousness in the equity market is reduced. Therefore, it will be enough for the G7 finance ministers and central bankers to just frown at the upcoming meeting, but they need not pull the trigger.
 
G7 statement on exchange rates (9 February, 2008): .We reaffirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to monitor exchange markets closely, and cooperate as appropriate. We welcome China's decision to increase the flexibility of its currency, but in view of its rising current account surplus and domestic inflation, we encourage accelerated appreciation of its effective exchange rate.

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Published on  Mon, Apr 7 2008, 14:31 GMT