How to Target Exchange Rates: G7 Countries Should Allow Their Currencies to Fluctuate within Agreed EMS-Style Ranges

Article published in the Financial Times

November 20, 1998

In its recent statement on reforming the world's financial architecture the Group of Seven largest industrial economies entirely ignored exchange-rate relationships among its own currencies.

This omission would be understandable if the behaviour of G7 exchange rates had had much connection with underlying changes. But G7 currency gyrations in recent years have far exceeded any conceivable shifts in economic fundamentals. The dollar rose by 80 per cent against the yen and 40 per cent against the D-Mark from early 1995 to mid-1998 and late 1997 respectively. One result is that trade deficits in the US are at record levels, generating strong protectionist pressures despite a 25-year low in the US unemployment rate. Another is that the Asian crisis is intensifying: every 10 per cent decline of the yen takes Dollars 20bn off the trade balances of the rest of Asia. The sharp swings in the yen-dollar rate contributed to the outbreak of the Asian crisis in the first place. Most recently, the yen jumped by almost 20 per cent in just a few days last month.

The instability of the dollar, yen and European currencies is likely to worsen with the creation of the euro. The euro-zone will resemble the US: a continental economy with modest reliance on external trade. It will be tempted to emulate America's tradition of benign neglect of the currency. This is especially true in light of the the European Central Bank's mandate to focus on price stability, which implies the absence of any explicit policy towards the exchange rate. The dollar and euro will provide the bulk of global finance, and large fluctuations between them will be highly disruptive for the rest of the world.

Indeed, in the short run, large shifts from the dollar into the euro could produce an overshooting of the new currency, triggering more unemployment in Europe and renewed inflationary pressure in the US. So the absence of an agreed framework to manage currency relationships could be costly on both sides of the Atlantic.

Hence it is fortunate that the new German government has launched an initiative to achieve "controlled flexibility" of the yen, dollar and euro. Gerhard Schroder, chancellor, and Oskar Lafontaine, finance minister, are surely correct that both rigidly fixed and freely flexible exchange rates have been tried and found wanting. Fixed rates, unless carried to the extreme of monetary union, as in Europe, or a currency board, as in Argentina or Hong Kong, have proved too prone to degenerate into costly over- and undervaluations. Flexible rates tend to overshoot wildly and generate equally disruptive misalignments.

The goal of currency reform should be a "third way" between these two extremes. For the G7 this goal can best be pursued by maintaining substantial flexibility but modifying the method by which it is managed. For the past decade, the G7 has intervened periodically on an ad hoc basis without prior announcement. This technique has the advantage of surprising the market, and has frequently succeeded (for example, to defend the dollar in 1995 and to defend the yen in 1998). However, the interventions have always come long after misalignments have set in and severe economic damage has resulted. The absence of official guidance has left, indeed led, the markets to drive rates far from their long-term equilibrium levels.

A better approach would be to announce limits on the extent of permissible swings, starting perhaps as much as 15 per cent on either side of agreed currency mid-points (as in the present European Monetary System). Rates would still float virtually all the time, as in the EMS. Any long-term disequilibria would be avoided by adjusting the ranges by very small amounts, which would be necessary to offset inflation differentials among the participants.

Within the wide limits envisaged, the G7 governments could surely agree on ranges that reflect under-lying economic reality and are credible to the markets. Private speculation would then become stabilising rather than destabilising. As a rate approached the edge of arange, little money would be made by pushing further in the same direction because the markets would know that the authorities would not permit the limits to be breached. In contrast, considerable profit could result from reversing the rate back towards (or beyond) the mid-points. Both theory and empirical evidence from similar regimes that have already existed, such as the EMS since 1993, demonstrate that such "mean reversion" can be expected with some confidence

Nevertheless, a rate might occasionally reach its limit and require official response. The initial instrument would be direct intervention in the foreign exchange market by the central banks. To assure credibility, however, participants would have to be prepared to alter their monetary policies to defend the ranges. In such instances, as Paul Volcker, the former US Federal Reserve chairman, has argued for the US, a country's long-term economic health would almost certainly be promoted rather than undermined by heeding the signal from the currency markets. With wide margins and credible national policies, however, the need actually to change monetary policy for currency reasons would probably be quite rare.

Similar considerations apply to emerging market economies. The Asians' dollar pegs led to substantial overvaluations and large trade deficits. Their subsequent resort to free-floating regimes produced wildly excessive depreciations that forced them to deploy sky-high interest rates, further weakening their banks deepening their recessions. They too should consider intermediate currency regimes, perhaps based on a common link to a trade-weighted basket of G7 currencies. Colombia, Chile and a number of other countries have used such systems successfully in the past.

G7 officials will meet this weekend in Washington to discuss the international financial architecture. They should fill the "currency vacuum" as soon as possible, both to avoid damage to their own economies and to fulfil their responsibility for imparting stability to the global system as a whole.