Exchange rates : The boot is now on China’s foot

Last week’s annual meeting of the World Bank and International Monetary Fund (IMF) may go down as one of the least significant in the history of the Bretton Woods institutions, which were planned in 1944 in order to ensure that the world would thenceforth avoid the ill-conceived economic policies and beggar-my-neighbour protectionism that contributed to the outbreak of the Second World War. Nothing much happened at last week’s meetings, although there was an awful lot of talk. But, paradoxically, it is precisely because nothing much happened that the meetings may be remembered.

This year’s meetings were preceded by a minor Wall Street crash, if only to demonstrate that they marked the 20th anniversary of Black Monday (October 1987), which had been precipitated in part by open disagreements on the fringes of that year’s IMF meeting between two members of the G7 — namely America and West Germany — about monetary and exchange rate policy.

This year’s meetings were preceded by the US sub-prime crisis and its ramifications. I say preceded, but they will also be followed by the ramifications. This is because if there was one thing senior policy-makers (and former policy-makers, whose reflections at fringe meetings I often find more penetrating than those of the current power brokers) are agreed upon, it is that we have nowhere ever seen the last of what is known in the trade as the credit crunch.

In which context it is my sad duty to note that the Northern Rock bank crisis in the UK was a big topic of conversation in Washington, and some pretty catty remarks were being made by international monetary experts about a country that claims to be the greatest international financial centre since Ancient Rome, but which so patently mishandled the Northern Rock affair.

However, the point made by one senior (present) policy-maker last week was that the sub-prime crisis was merely the trigger for an inevitable reaction to the insanity of the financial markets’ ‘search for yield’, in a world where a glut of (mainly) Asian savings had reduced long-term interest rates to low and boring levels. The ‘search for yield’ led to the abandonment of sensible investment criteria and the proliferation of so called ‘structured investment vehicles’, whose relationship to real vehicles is their ability to crash, and whose second-hand value is now being disputed in the courts, as banks and other financial institutions write off hundreds of millions of debt.

These financial institutions are now drawing in their horns when it comes to future lending, with obvious implications for advanced economies such as the US and UK, where consumer demand until recently has been fuelled by a ‘borrow, borrow... spend, spend’ approach, often in the belief that the value of the collateral (property) would go on rising at sensational rates (not that many US mortgage firms even bothered to ask for collateral, it seems).

Another important point, made by former senior policy-makers, was that just as the more historically minded participants and observers knew in their bones that the credit binge would end in tears (the works of the economists Charles Kindleberger and JK Galbraith should always be within reach) but nobody did anything about it, so the writing is on the wall for those who believe the present chaos in the world’s foreign exchange markets will not end in disaster.

After the Bretton Woods system of fixed (but adjustable) exchange rates broke down in the early Seventies, we were told that, via floating exchange rates, the markets would, in their wisdom, produce a benign outcome, not least if inflation were brought under control. We now have a world in which some key currencies float, and others — Asian currencies in general and the Chinese yuan in particular — are heavily controlled by their governments, and the controlling countries accumulate masses of foreign currency.

These policies date back to the Asian financial crisis of 1997 and the US government’s strong opposition, at that year’s IMF meeting, to the proposal for an Asian Monetary Fund. The Asian response was to make sure they would never be caught short again, and they proceeded to build up their reserves.

Financial markets tend to push things to the limits. The fact of the matter is that, with the Chinese pursuing an essentially beggar-my-neighbour exchange-rate policy, most of the strain of the decline in the dollar is being taken by the euro and the pound.

The IMF came in for heavy criticism last week for failing in its main duty of policing exchange rates. We need some kind of move on the lines of the Plaza agreement of 1985 to bring order to exchange rates. Experience suggests that there is progress in such matters when the US sees it as in its own interest. However, there has been a huge shift in economic power since 1985, and the boot is now on the Chinese foot. The omens are far from propitious. — The Guardian