No one can afford to ignore the `speculators' - or have them shot

As the world's banking community converges on Hong Kong where the IMF and World Bank annual meetings start next week, both the bankers and the currency traders who work for them will be reflecting on how much more turmoil on the foreign exchanges this year can bring. This is not just a question of the recent crisis affecting several Asian currencies, which prompted Malaysia's prime minister to say he thought speculators should be shot. Volatility in the exchange rates between major currencies like the dollar, yen, mark and pound has also been much higher this year than last.

It is not in the nature of central bankers to like volatility, although the investment bankers love it, of course, for the extra business and profit opportunities it brings. As last spring's G7 ministers' meeting put it in the official communique: "We agreed that exchange rates should reflect economic fundamentals and that excess volatility and significant deviations from fundamentals are undesirable."

Therefore the financial markets will be a bit edgy about the meeting of G7 finance ministers and central bank governors due to take place in Hong Kong in just over a week's time. They will also be keeping a cautious eye on any smoke signals emerging from this weekend's meeting of European finance ministers, which is due to discuss the exchange rates at which member currencies will convert to the euro at the end of next year.

Given that those attending these two key policy meetings have a strong preference for exchange rates that do not move too far, too fast, and reflect underlying economic fundamentals, the markets will be speculating whether they might do anything about it. In April there was talk but no co-ordinated intervention and no change in policies. But two years earlier the G7 did manage to bring to reverse the dollar's earlier decline. Will the ministers walk their talk this time around?

Generally, action takes place only when the strains of misaligned currencies have become unbearable. Economists at Goldman Sachs have helpfully just published a chunky document which gives their latest estimates for "equilibrium" exchange rates which would reflect fundamentals. They calculate that the dollar ought to be around $1.50 to the mark in the long run, and the pound should be at DM2.49. The equilibrium dollar-yen rate is 111.95.

This means that at current rates, the dollar is substantially overvalued against the German mark, though much less so against the yen, while the pound is still overvalued despite its recent decline. Generally speaking, the mark is far too weak, the dollar and the pound too strong.

The first action G7 ministers and central banks always take is to try to talk their currencies down - or up - without having to intervene directly in the foreign exchange markets or do anything really drastic like alter interest rates or government budgets.

The talking has started. For example, the Bank of England successfully persuaded the currency markets that the pound should be lower with a statement last month that indicated interest rates were unlikely to rise again in the immediate future.

On Tuesday Lawrence Summers, the US Deputy Treasury Secretary, launched a verbal assault that took the dollar down more than two yen in a day by saying the Japanese government must promote domestic demand, rather than relying on exports to haul the economy to recovery.

Other central banks have quietly stopped buying US Treasury bonds during the past four months. If private investors do not plug the emerging gap, the dollar is likely to fall. An increase in US interest rates would postpone this correction but interest rates are likely to increase in Germany as well, and perhaps also in the UK eventually.

Besides, its growing trade deficit means America's appetite for foreign capital is huge. To finance its gap between imports and exports of around $190bn (pounds 120bn) this year it would have to soak up all the spare savings in the rest of the G7. To make matters worse, Japan and other Asian countries have bought about a third of the foreign purchases of Treasury bonds during the past two years. Recent events mean this supply of capital inflows will probably dry up.

As the Goldman Sachs experts point out: "In the past two years we have witnessed the swiftest acceleration of foreign capital inflows into the US Treasury market on record." If they slow down markedly - perhaps as a result of decisions taken or signals sent at the impending G7 meeting - either long-term yields in the US will have to rise or the dollar will have to set off on a downward path to provide overseas investors with a currency gain.

The real moral is that the American government can no more ignore the currency markets than the Thais or Malaysians. According to the last international survey in 1995, daily foreign exchange turnover was $1.2 trillion. Next year's update will show that it has grown even more. This is too formidable a scale for any government to tackle. All are subject to the market's disciplines, when the "speculators" get round to applying them.

Countries like the US with a big current account deficit are consuming more than they can produce at home - a trade shortfall is often the earlier sign of inflationary pressure. If, as seems to be the case in America at the moment, this is because of growing purchases of investment goods, it need not be a long-term problem. The investment will eventually increase home production. Even so, it will put the currency under pressure and in the end is likely to result in a depreciating dollar. If, as in the South-east Asian case, it is the result of consumer spending or unproductive government spending, the crunch will be rapid and painful.