The communiqué of the G20 meeting last weekend is surprising in several respects:
First of all is the strong reaffirmation of the virtues of an unfettered “free market” in which FX rates should be allowed to find the “own” level without “intervention” other than an unspecified commitment by the major economic powers to correct excessive “ current account imbalances”, be they deficits or surpluses.
Such a statement contrasts with the quasi unanimous diagnosis that “totally free and unregulated markets” contributed significantly to the unfolding of the financial crisis. It is difficult to understand why a “dogmatic” exception should be made for the FX market, even if it is true that, during the initial stages of the crisis, this particular segment of the financial markets continued to function smoothly contributing to the stabilisation of the global economy.
While there is certainly great wisdom in the proposition:“If it ain’t broke, don’t fix it”, recent tensions in exchange markets indicate that it is imperative that authorities give themselves the necessary tools to deal with the detrimental effects that turmoil in FX markets could have on a still very fragile economic recovery.
Seeking to design an appropriate multilateral framework for FX market regulation seems all the more reasonable that FX flows deriving from underlying trade transactions represent only a small percentage of the overall volume of activity that transits daily over FX markets. Far from underestimating the importance of restoring sustainable long term equilibrium in trade through the elimination of “structural (as opposed to cyclical) imbalances”, it seems however totally unrealistic to believe that it can ensure the prevention of erratic FX fluctuations. Their detrimental effects on normalised trade flows will increase commensurately the temptation for protectionist measures by countries whose currencies are not used for invoicing international trade.
Indeed, FX transactions originate also from the important flows linked to “direct” as well as “portfolio” investments or other perfectly legitimate “hedging” transactions that are part of highly desirable “risk management” operations aimed at protecting the financial integrity of economic operators. Reinforcing “risk management” is high on the priority list of the new Authorities overseeing “systemic risk”.
Two additional areas contribute significantly to the volume of FX transactions and impact the level of FX rates:
The first results from “imbalances” in government finances which, in the prevailing free FX market environment, may induce large undesirable increases or decreases of highly “mobile” investments that are particularly sensitive to interest rate and inflation expectations. These factors are often more highly correlated to the sustainability of appropriate government budgetary policies than to less volatile trade flows. It seems therefore not unreasonable that monetary authorities wish to have the possibility to implement appropriate “dissuasive” measures to prevent unwelcome short term inflows that could hurt competitiveness (in case of upward pressure on the currency) or, conversely, expose the country to the detrimental effects of a sudden withdrawal of liquidity. A globally negotiated framework for this type of “intervention” would appear desirable to ensure sufficient coherence and eliminate competitive distortions due to FX fluctuations.
The second area, which I have deliberately left for the last because of its nebulous definition and often sulphurous connotations, relates to what is often referred to as “purely speculative flows”.
There is no doubt that operators take “positions” in various financial instruments with the sole objective to benefit from a price fluctuation totally unrelated to any other economic interest and that can induce severely damaging consequences. Such behaviour has led to widespread criticisms, for instance in the well publicised case of “attacks” on € denominated sovereign debt securities and their related CDS derivatives which translated into significant simultaneous weakness of the Euro. Indeed, when such positions relate to instruments denominated in another currency they are automatically accompanied by FX transactions which, unless covered by a forward repurchase or sale, have a direct impact on the corresponding FX rate. Such “open positions” can have as objective to benefit from fluctuations in the price of the instrument and/or the value of the currency.
One should note that such an approach is hardly different from any other “investment strategy” – stock purchases for instance - where profiting from price fluctuation is the main object. In addition these “speculators” perform a useful purpose as they serve as counterparties to those who seek an opposite exposure, for instance for wholly rational hedging or risk management purposes. They also add to the liquidity of the market reducing costs by allowing tighter spreads between bid and offer quotes.
In addition to adjusting “trade imbalances”, complemented by multilateral budgetary surveillance to be carried out by the IMF globally and by the Commission within the EU (the new “Semester” procedure), a lot can be accomplished to stabilise FX markets by “regulating” the trading of underlying instruments through measures governing “short selling”, “mark to market”, “exchange based trading and settlement requirements” etc.
However, leaving FX markets totally unencumbered, as recommended by the Ministers, leaves ample room for purely “speculative flows” to “pollute” the fixing of FX rates because it will be nigh impossible to discriminate between transactions that are considered “legitimate” from those who are deemed not to be.
Exclusive or excessive reliance on containing “current account” imbalances within acceptable limits as the means of avoiding FX turbulence, can lead to neglect other causes of FX disruptions which in turn can backfire and destroy the efforts undertaken, notably by the WTO, to create a level “trading field”.
Consequently, Regulators and Supervisors should therefore develop a coherent set of rules and a tool kit containing the appropriate intervention mechanisms to ensure that the FX market does not become the main focus of “residual” harmful speculative attention.
Brussels, October 26th 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
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