必须预防美元大跌

The rebound of the dollar at the height of last year's financial crisis was one of the few silver linings for policymakers. Increased risk aversion prompted investors to return to the safety of liquid US Treasuries, averting a collapse of America's currency.

This year the greenback has weakened again as risk-seeking US investors have bought higher-yielding foreign assets. This dollar weakness should be benign and the currency is likely to strengthen if investor bullishness eases. But a collapse of the dollar would have grave consequences for the world economy. Already officials at the Bank of Canada and the Reserve Bank of New Zealand are warning about developments in the currency markets. This month G20 policymakers should discuss exchange rates when they meet in Pittsburgh.

A plunge in the dollar would hurt America's economy. Foreign investors would demand higher returns for holding US assets, causing bond yields to steepen. But extreme dollar weakness also poses a threat to the rest of the world. For most of this decade, the world economy has been able to accommodate sliding currencies as global growth has boomed. But in the credit crunch world, a super-weak dollar risks exporting deflation across the globe.

In the rich G7 economies, official interest rates are very low, central banks are printing money and finance ministries are running big fiscal deficits. This leaves policymakers with little scope to deal with a sudden appreciation of their currencies against the dollar. In the worst-case scenario, a rout of the greenback could tip some G7 countries into liquidity traps where extremely loose monetary and fiscal policies are unable to prise their economies out of deflation.

It is only a short step from debt and depression to governments resorting to protectionism. To avoid this ruinous path, the G7 should be prepared to act in the currency markets should the dollar plunge unexpectedly.

Over the last three decades there have been five bouts of co-ordinated intervention in the major currencies. In 1985 the G7 signed the Plaza Accord to weaken the dollar. In 1987 the G7 changed stance at Louvre and pledged to support the falling greenback. Similarly, in 1995 the G7 again decided to intervene to help America's currency. In 1998 America and Japan sold dollars to prop up the yen. And in 2000 the European Central Bank persuaded the Federal Reserve and the Banks of Japan, England and Canada to support the euro.

Four of these five episodes were ultimately successful in changing the trend of the currency markets. In 1985 the dollar stopped overshooting against the yen and the German mark. In 1995 the greenback began a sustained rally that lasted throughout the late 1990s. In 1998 the "yen carry trade" reversed sharply to the benefit of Japan's currency and in the early 2000s the euro rarely traded below the levels where the G7 central banks had intervened to support it.

The Louvre Accord is the one exception here. Though the G7 agreed in February 1987 to help the greenback, the dollar continued to slide as Germany's Bundesbank increased interest rates in the summer. This caused bond yields to rise around the world, eventually causing Wall Street to crash in October 1987.

The lesson for policymakers therefore is that co-ordinated intervention can work in the currency markets but it needs to be consistent with changes in interest rates globally. This matters now as the Federal Reserve intends to keep the Fed funds rate very low well into 2010. In order for co-ordinated intervention to be successful, the rest of the G7 will thus need to consider cutting interest rates. In short the onus would be on the European Central Bank to lower its refinance rate from 1.00 per cent as the central banks of Japan, Canada and Britain already have interest rates at or below 0.50 per cent.

Subordinating monetary policy to exchange rate policy would be painful for institutions like the ECB. But the experience of 1987 shows plunging exchange rates can cause severe shocks to financial markets and the world economy. The G7 should have a plan in case of renewed turmoil in the currency markets.

The writer is managing director of foreign exchange strategy at UBS investment bank