The following article has been published on July 8 2009.
Exchange rates can exacerbate crisis
From Prof Patrick McNutt.
Sir, Commentary on the financial crisis seldom addresses the significance of exchange rate volatility. That may change soon. Both the World Trade Organisation and the World Bank have warned about the rise in protectionism. China believes that currency issues should be discussed at the Group of Eight meeting this week in Italy.
The question therefore has to be asked: should the issue of exchange rate volatility be part of a co-ordinated solution to our world financial crisis?
The answer is in the affirmative. Big holders of US dollar reserves, such as China, may be rethinking the dollar’s role as a reserve currency. It is a signal of a rethink on currency alignments at a time when world leaders are more focused on fiscal stimulus, regulatory reform and socialising banks’ losses.
As the value of US dollar reserves fluctuate, and trading nations adopt protectionist policies, big holders of dollar reserves may switch to (say) the euro in a signalling game of tit-for-tat policies, and if that were to continue over the next year the dollar’s role as the world’s main reserve currency unit could be compromised.
There is a solution. A managed exchange rate regime, for two to three years, negotiated with agreed rate bands and appropriate escape clauses for governments reliant on fiscal and monetary policy, would be a key signal from world leaders at their meeting in Italy and would help to arrest a nascent uncertainty in this financial crisis.
This is not a call for a fixed exchange rate regime per se; it is a call to recognise that while exchange rate volatility may not have contributed to the financial crisis, it may have the potential now to exacerbate the crisis.
World leaders are emerging as players in a non-cooperative signalling game on currency issues, a game that began at the G20 in April.
Unless currency issues are addressed at the G8 meetings in Italy, “currency signals” will undermine world economic recovery.
Manchester Business School, UK
Copyright The Financial Times Limited 2009