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The Dollar, the Yen and European Currencies

Address by Michel Camdessus
Managing Director of the International Monetary Fund
at the XIV Sesiones de Trabajo de Tesoreria, Caja de Ahorros de Navarra
Pamplona, Spain, November 17, 1995

I cannot find the words to express how pleased I am to be in Pamplona. It is like visiting an ancestral home. My forebears from the Béarnais region in France were subjects of the kings of Navarre for many more centuries than they were citizens of the successive French republics! I have not visited Navarre for many years; it is delightful to see how it has been able to remain on the cutting edge of progress in this century and at the same time breathe new life into its traditions and culture.

Ladies and gentlemen, we live in a time of great changes in the international monetary and financial order. In particular, Japan's remarkable economic performance in recent decades, together with Europe's continued economic growth and integration, has produced a more tripolar constellation of currencies. While the dollar still predominates, more international transactions are taking place in yen and European currencies. It follows that responsibility for promoting exchange rate stability is now more broadly shared among the United States, Japan and Europe--a situation that will not last forever, of course, given the impressive performance of a number of emerging economies.

At the same time, however, the globalization of financial markets, brought about by recent technological changes, financial market liberalization, and the removal of capital controls, has increased the power and agility of private financial markets on such a scale as to defy the imagination. According to a recent survey by the Bank for International Settlements, daily turnover in these markets is now over $1.2 trillion.

In my remarks to you today, I would like, first, to examine the respective roles of the dollar, the yen and European currencies in the world economy, as well as the exchange arrangements under which they operate. Second, I will consider the effectiveness of the existing arrangements--which is questionable--with respect to exchange rate stability. Finally, I will explore what, in the face of powerful markets, governments and the IMF can do to encourage greater exchange rate stability.

Let us begin with a brief look at the respective roles of the dollar, the yen, and European currencies. Although they share certain characteristics, they nevertheless have very different roles in the international monetary system.

The dollar remains the most international of the world's currencies. It is, for example, the currency in which most of the world's official reserves are held. During the decade of 1985-94, about 54 percent of total official holdings of international reserves were, on average, denominated in dollars, versus about 15 percent in deutsche mark, 8 percent in yen, 3 percent in pounds sterling, and 2 percent in French francs.1 The dollar is also the currency in which most foreign exchange transactions take place. According to the Bank for International Settlements survey I just mentioned, the proportion of transactions involving the dollar stands at 83 percent, versus 37 percent for the deutsche mark and 24 percent for the yen.2 Similarly, most trade transactions are denominated in dollars. For example, nearly half of the exports of industrial countries are denominated in dollars, compared with about one quarter in deutsche mark, and only one tenth or less each in pounds sterling, French francs, and Japanese yen.3

While the yen also has some international role, it is primarily a national currency. As indicated by the data I mentioned, the role of the yen is not commensurate with the relative size of the Japanese economy or with Japan's emergence as the world's largest creditor country. This observation is also borne out by the relatively low use of the yen as an invoicing currency for Japanese trade. While nearly all U.S. exports are denominated in dollars, over 80 percent of German exports are in deutsche mark, and more than half of French and British exports are in these countries' currencies, only a third of Japanese exports are denominated in yen.4 Even at the regional level, the use of the yen is relatively limited: only 40 percent of Japan's exports to other countries in the Asia and Pacific region, and 20 percent of its imports, are denominated in yen. On the other hand, the yen is part of the currency basket used to value the SDR, together with the dollar, the deutsche mark, the French franc, and the pound sterling.

Most European currencies are also primarily national currencies, but some of them are important regionally and the role of the deutsche mark to some extent transcends the region. Because of Germany's place as the largest European economy and its record as a low inflation country, the deutsche mark has emerged as the most important European currency and the linchpin of the exchange rate mechanism (ERM) of the European Monetary System (EMS). Interestingly, in some European currency markets, including those of France and Spain, the volume of transactions in deutsche mark now exceeds the volume of transactions in dollars--a development that appears to reflect the growing importance of the deutsche mark in an increasingly integrated Europe.5 The deutsche mark is also used extensively in Central and Eastern Europe.

It is also interesting to note that while there are 23 countries that peg their currencies to the dollar, and 25 countries whose currencies are linked through the EMS (including 14 African countries that peg to the French franc), there are no currencies pegged to the yen. Thus, while there is in this sense a "dollar zone" and a zone centered on the EMS, a "yen zone" has yet to develop.

Some of the consequences of these countries' exchange rate arrangements are also of interest. Since the end of the Bretton Woods system of fixed exchange rates in 1973, the dollar, the yen, and the deutsche mark have operated under a regime of managed floating. That is to say, while there has been no fixed relationship among these three currencies, none of the issuing countries has been completely indifferent to its bilateral exchange rates vis-à-vis the other two. Thus, although policymakers in these countries have generally focused on domestic economic policy objectives, they have at times used exchange market intervention or policy shifts to affect the exchange rates of their currencies.

This contrasts sharply with the exchange rate mechanism of the EMS. When first initiated in 1979, the ERM was seen as a method to reduce volatility among European currencies. In the early 1980s, the focus shifted toward controlling inflation and macroeconomic convergence, with members' commitments to maintain exchange rates within certain bounds being used as a nominal anchor. Most recently, the ERM has become an essential part of the movement toward European monetary union (EMU).

Notwithstanding differences in the roles of their currencies and in the exchange rate arrangements under which they operate, the United States, Japan, and Europe all have a special interest--and a shared responsibility--in seeing that the international monetary system functions smoothly. This is not an end in itself, but a means of promoting international trade, as well as capital flows, with the aim of achieving high levels of growth across the global economy.

How well have current arrangements worked? Overall, the exchange rate system in effect since 1973 has proven to be reasonably resilient, at least. It was able to cope with the oil crises of 1973 and 1979 without producing significant strains in exchange markets. It was also able to accommodate differences in countries' cyclical conditions in the 1980s and 1990s. The system has likewise adapted relatively smoothly to the changes in the global economy, especially the expansion of financial markets and the growing importance of Japan and Europe in these markets. Moreover, by enhancing monetary and fiscal discipline among participating countries, the EMS has helped narrow inflation and interest rate differentials, thereby creating a zone of relative stability in Europe and helping to promote intra-European trade.

Nevertheless, neither the managed floating practiced among the Group of Seven industrial countries nor the ERM has worked as well as many of us would have liked.

Since the breakdown of the Bretton Woods system there has been a dramatic increase in exchange rate volatility--that is, the short-term, day-to-day or month-to-month variability of nominal exchange rates. Over the past two decades, the exchange rates of the dollar, the yen, and the deutsche mark have been much more volatile than they were before 1973, and more volatile than consumer price indices or other measures of economic performance that exchange rates supposedly reflect. Of course, under a floating rate system, a certain amount of volatility is natural and reflects the healthy flow of information among market participants. Moreover, the consensus is that the negative effects of exchange rate volatility on trade and investment are actually relatively small. However, individual firms that are active in international trade may not share this view, since exchange rate volatility increases uncertainty, and the expense of hedging against exchange risk drives up business costs. Indeed, as I mentioned, one of the reasons the ERM was established was to reduce exchange rate volatility. And, in fact, the evidence suggests that it has.6

Of much greater concern, however, is the emergence of currency misalignments--that is, when exchange rates depart from economic fundamentals for relatively long periods or reflect inappropriate or unsustainable economic policies. Although "equilibrium exchange rates" are hard to define precisely, major misalignments can generally be discerned. As occurred in the mid-1980s, for example, with the overvalued dollar, such misalignments among the world's major currencies can cause serious damage--by misallocating resources, deepening adjustment problems, fueling protectionist pressures, and increasing trade frictions. At times, misalignments have also emerged within the EMS, causing turmoil in exchange markets and undermining the credibility of the established parities.

In view of these problems, how can countries promote exchange rate stability more effectively? A look at past experience provides some important lessons.

Let us consider, for example, the EMS crises of 1992 and 1993--in which the pound sterling and the lira left the ERM, the Spanish peseta and the Portuguese escudo were devalued, and ERM exchange rate bands were widened considerably. First, these events demonstrated how powerful private transactions in exchange markets could be. The resources mobilized by the private sector generally far exceeded the amounts that country monetary authorities could muster to protect the parities.

Second, and perhaps far more importantly, these episodes showed how perilous it could be to place too much reliance on an exchange rate regime--and not enough on the underlying economic policies. Indeed, the exchange rate pressures that emerged within the ERM during that period mostly reflected the build-up of macroeconomic imbalances in Europe. These included Germany's mix of tight monetary and expansionary fiscal policies during reunification, the United Kingdom's difficulty in following Germany's monetary policy lead in the midst of a long recession, and doubts about the lira's central parity and future in the EMS, given Italy's loss of competitiveness during previous years and its large budget deficit. At the same time, Spain's and Portugal's relatively high inflation rates cast doubt upon the sustainability of their currencies' ERM parities as well. Developments in 1992-93 clearly illustrated that markets do not remain under a spell forever.

These lessons about the importance of economic fundamentals and the power of markets also apply to the periodic efforts of major industrial countries to influence exchange rates among the dollar, the yen, and the deutsche mark. For example, the success of the G-5 countries in engineering a "soft landing" for the dollar in September 1985 should not be credited simply to the official statement issued from the Plaza Hotel or to the coordinated intervention that followed, although both provided helpful signals to the market at the time. Rather, the Five were successful because economic fundamentals in their respective countries and the policies they were pursuing were consistent with a lower dollar. It was only in this context that the G-5's official statements and coordinated central bank intervention could succeed.

To take another example, the failure of major countries to maintain the "reference ranges" that they had established for the dollar, the yen, and the deutsche mark at the Louvre in February 1987 resulted from their relying too heavily on official pronouncements and not giving sufficient attention to the policies needed to maintain the "ranges." Indeed, as time passed, the three largest countries became increasingly preoccupied with their own domestic problems: the United States, with recovery from the 1989-91 recession; Japan, with managing its financial crisis; and Germany, with reunification. And while all of these issues merited policymakers' attention, it is regrettable that certain mechanisms that would have resulted in a better mix of policies fell by the wayside.

In view of these experiences, what should governments do--not only to prevent exchange rate misalignments--but also to promote exchange rate stability in general in this new environment of globalization, where it is needed more than ever?

First, when macroeconomic imbalances do occur, they should be corrected as soon as possible in order to reduce the risk of greater market turmoil. When imbalances are allowed to persist, credibility suffers, and stronger action to correct the imbalances is likely to be required in order to demonstrate government resolve. At times, there may be a limited role for exchange market intervention, but only as a temporary signal to markets that they should take a closer look at economic fundamentals. And without policy changes, it may be difficult to convince currency markets that exchange rates are out of line with longer-term fundamentals.

More fundamentally, however, countries must recognize--and live up to--their international responsibilities. Although the dollar, the yen, and European currencies play different roles in the international system, their prominence in the world economy implies special obligations for the United States, Japan, and European countries. In particular, these countries must recognize that the behavior of their currencies is not a matter of indifference for the rest of the world. Indeed, fluctuations in the dollar, the yen, and European currencies, as with changes in other macroeconomic variables, such as interest rates and GDP growth, have important spillover effects on the world economy.

Since the United States has the largest economy and the most important currency, it has a particular responsibility. This includes pursuing a mix of monetary and fiscal policies that promote price stability and enhance domestic savings; it also includes cooperating with other nations in promoting exchange rate stability. However, such obligations are by no means limited to the United States--Japan and Germany also have important roles to play, as do other European countries. In particular, they must all recognize that by helping to ensure that the economic fundamentals are sound in their own countries, they can make a major contribution to improved economic performance in the world economy and thereby to enhanced exchange rate stability. In this regard, European countries should also recognize that their efforts to strengthen economic policies and promote stable European exchange rates will not only strengthen growth prospects in Europe, they will also benefit the world economy.

Fortunately, major progress has been made toward achieving reasonable price stability. Inflation rates in nearly all of the industrial countries have converged to their lowest levels in three decades, and countries appear determined to preserve this accomplishment. Some headway has been made in fiscal consolidation, but considerably more action is needed--especially in view of the aging populations in industrial countries--to reduce fiscal deficits and levels of public debt as a share of GDP. In most countries, the emphasis will need to be on cutting expenditure, which, assuredly, no one likes! As governments exhaust the scope for cuts in current expenditure, they will be forced to reform major transfer programs--including pension and health care systems, subsidies, and indexation schemes. And Spain, too, must address this need.

At the same time, other structural reforms must also be undertaken. In Japan, further action is needed to strengthen the domestic banking system, and to deregulate the economy and expose it to greater competition in world markets. In Europe, reforms are needed to enable the labor markets to function more smoothly and to reduce structural unemployment. An effective labor market reform that successfully addressed the problem of structural unemployment could help reduce fiscal deficits, as well as enhance the credibility of longer-term plans for fiscal consolidation. This, in turn, could create a "virtuous circle"--where labor market reform contributes to fiscal consolidation, thereby helping to ease interest rates, and where lower interest rates contribute to investment and growth, thereby improving employment prospects. This is feasible, and would be the surest way of easing the current tensions in European currency markets, which could well intensify.

How does the IMF contribute to exchange rate stability and, hence, to more sustainable growth in the world? Basically through its surveillance activities. Surveillance is based on the conviction that strong and consistent economic policies will lead to a stable system of exchange rates and a more prosperous world economy. Toward this end, the IMF holds regular, thorough, and frank consultations--usually once a year, but more often when necessary--with each of its 180 members. These consultations, which cover the full range of fiscal, monetary, exchange rate, and structural issues, allow the Fund to provide the entire membership with a candid assessment of each member's economic policies, performance, and prospects.

Of course, the private financial markets also provide their own form of surveillance. And indeed, the prospect of market discipline can be very beneficial in maintaining the resolve of government policymakers to pursue strict economic policies. However, the discipline exercised by the market is not always smoothly and consistently applied. The IMF, through its surveillance activities, can encourage timely policy adjustments before exchange markets force these adjustments to be made in a far more costly way. Moreover, as the main forum for international monetary cooperation, the IMF endeavors to bring about cooperative solutions to exchange rate problems and global macroeconomic maladjustments.

The messages that the IMF is conveying to member countries in the course of its surveillance activities are clear: the need to maintain reasonable price stability; the need for fiscal consolidation and structural reform; and the urgency of tackling these difficult tasks now, while the world economic situation and prospects are generally favorable. These messages apply not only to the industrial countries on which I have concentrated my remarks today, but to the IMF membership as a whole. It is worth noting that it was the very strong performance of 35-40 developing countries applying IMF-inspired or similar policies that prevented world recession in 1991-92. In addition, the major recent shocks to the international system--I am thinking of the Mexican crisis, for example--also had their origins outside the G-7.

Particularly in response to the experience with Mexico, the Fund has given considerable attention to the ways in which its surveillance can be strengthened so that emerging problems can be more readily addressed before they become crises. Accordingly, we are endeavoring to ensure more regular and timely provision of data to the Fund by member countries, intensifying our dialogue with country authorities, and paying greater attention to the soundness of domestic banking systems, to financial flows and their sustainability, to countries where risks are greater, and to countries where financial market tensions are likely to have spillover effects. At the same time, we are developing standards to guide members in the provision of economic and financial data to the public, so that markets will be better informed and less prone to surprises.

Turning back to recent exchange rate action among the industrial countries, I would add the following observations.

First, I am encouraged by the industrial countries' action last August to reinforce the dollar's slight recovery from its low against the yen, and it is important that they build upon this achievement. Although it is difficult to say exactly what the most appropriate exchange rate structure might be, it is clear that when the yen reached about ¥80 to the dollar--beyond any relationship consistent with economic fundamentals--the market got it wrong.

Today, major currencies seem to be within, broadly speaking, an acceptable range. That said, I would venture that the U.S. dollar continues to look weak against the deutsche mark and closely linked European currencies, as well as against the Japanese yen. Indeed, from a broader macroeconomic perspective, a stronger U.S. dollar and a slightly weaker deutsche mark and yen might seem appropriate given that the U.S. economy is operating near potential, that activity has been slowing in Germany and an overly strong deutsche mark may impede German export growth, and that recovery of the Japanese economy is lagging.

That is why I was pleased to note that, in the declaration of the G-7 ministers and governors in Washington in October this year, they welcomed the orderly reversal in the movements of the major currencies that had already occurred, would welcome a continuation of these trends consistent with underlying economic fundamentals, and reaffirmed their commitment to reduce imbalances and to cooperate closely in exchange markets. Consequently, I think the G-7 should at least resist a significant depreciation of the dollar from present levels.

For such an effort to materialize, however, the commitment must be credible. First, the G-7 must take into account the fundamental policy requirements for a stronger dollar and a more realistically valued yen over the medium and longer term--and must strive to satisfy these requirements.

Second, as regards European countries, I believe that their efforts to achieve monetary union should be continued, and in some countries intensified. I believe the union is feasible. Indeed, fiscal consolidation ought to go much further than the Maastricht criteria require. Above all, European countries must bear in mind that their adjustment efforts are essential--not only to fulfill Maastricht goals--but to ensure Europe's role as a dynamic force in the world as well.

Finally, for the IMF, I believe we should persevere in our efforts to maintain a candid dialogue with the G-7--one that permits the timely questioning of policies when they are not in line with the requirements for international stability, so that emerging misalignments can be corrected early, within a framework of cooperation. We should also persevere in our efforts to encourage the G-7 to exercise effective policy coordination--not just when exchange rate pressures become irresistible--but on a continuous basis, so that misalignments can be averted before they emerge.

In conclusion, I would stress that if countries want to achieve greater exchange rate stability--and I firmly believe that it is in all of their interests to do so--they must work for it. In addition to pursuing firm domestic economic policies, they must strive toward more effective multilateral coordination. What does this mean? It means that countries must make a greater effort to understand the economic policies of other countries and that they must listen to the judgment of others about their own national policies. It also means that they must take a more enlightened view of their own national interests, recognizing that it is in their own self-interest to take the interests of other countries into account. And finally, it means that they must have the leadership to act upon these principles. This is a hard task indeed, but one that is essential in an increasingly integrated world economy where a much broader and more exacting view of cooperation is required.

1. 1995 Annual Report, IMF.

2. Press communiqué, October 24, 1995, Bank for Interantional Settlements. Note that since each transcaction involves two currencies, the sum of all transactions in all currencies amounts to 200 percent.

3. Goldstein et al., Policy Issues in the Evolving Monetary System, IMF, June 1992.

4. Ibid.

5. Global Bank Biweekly, September 28, 1995, Solomon Brothers.

6. During the 1980s, for example, when the French franc was a member of the ERM, but the pound sterling had not yet joined, the variability of the French franc/deutsche mark exchange rate was considerably less than that of the pound/deutsche mark exchange rate.


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