11 August 2010
Ousmène Mandeng, Ashmore Investment Management
The most important price of the international economy has become increasingly jittery. The dollar/euro exchange rate volatility has reached its highest level since the final collapse of Bretton Woods of fixed exchange rates. Previous episodes of heightened eurodollar volatility have coincided with or an- nounced a major turning point in the eurodollar exchange rate. The importance of eurodollar suggests that there is sub- stantial uncertainty at the core of the international economy including but not limited to growth, fiscal policy and monetary policies. Its significance for the exchange market also suggests that it may risk contaminating other currency crosses. It is further an indication of a lack of policy coordination between the two main economic blocs. All this is potentially hugely damaging for the global economy. However, for emerging markets it may be the best reason yet to review the validity of their current exchange rate policies.
The eurodollar exchange rate has moved recently from US$1.51 on 25 November 2009 to US$1.19 on 7 June 2010 and is trading at US$1.30 on August 11. The November 2009 through June 2010 swing was a 21 percent appreciation of the dollar against the euro only to be followed by a depreciation about half way through early August. At end July, euro- dollar volatility, as measured by the annualized standard deviation, reached 17 percent, its highest ever, by the given measure, since 1973 (Chart 1).
Sharp exchange rate fluctuations have for a long time been one of the greatest puzzles of the international economy. There has generally been an assumption that observed greater convergence of inflation rates across countries should dampen exchange rate volatility. In the European Union, exchange rate stability and hence conditions for adoption of a common currency has long been seen as an outcome and coincident indicator of economic convergence. E.g. the Treaty on European Union (Maastricht Treaty) requires fulfillment of the following convergence criteria (article 109j): “The achievement of a high degree of price stability; this will be apparent from a rate of inflation which is close to that of, at most, the three best performing Member States in terms of price stability; the observance of the normal fluctuation margins provided for by the Exchange Rate Mechanism [ERM] of the European Monetary System, for at least two years, without devaluing against the currency of any other Member State.” Additional convergence criteria included indicators on public finances and long-term interest rates. The ERM stipulated a normal fluctuation margin of ± 2.25 percent against bilateral central parities but later accommodated a wider band of ± 15 percent which has also been maintained for the successor ERM II against the euro.
Economic convergence between the U.S. and Germany is of course less progressed than the criteria governing European integration. However, there has been some considerable convergence. In fact, taking inflation as a proxy for internal balances and hence a reflection of macroeconomic conditions overall, inflation levels have converged to some extent between the U.S. and Germany. The ratio of consumer price indices since the early 1970s shows that after sustained sig- nificantly higher inflation in the U.S., inflation levels have be- come more similar to some extent. The about twice as high cumulative inflation in the U.S. has translated though eventu- ally in a significant relative nominal price adjustment as the dollar depreciated against the German mark, the predecessor (de facto) of the euro, from DEM3.20 in January 1973 to DEM1.50 today.Yet, the convergence of inflation seems to have coincided with a reduction in the overall amplitude of ex- change rate changes. Markdollar after all provides a good illustration that exchange rates are determined by relative price levels at least over the medium-term (law of one price or purchasing power parity). It therefore seems that persistent high exchange rate volatility is to a large extent inconsistent with increasing actual economic fundamental convergence (Chart 2).
The high level of eurodollar volatility may reflect substantial uncertainty about the relative inflation outlook or other expected asymmetric economic shocks. Sharp policy divergence is of course a possibility and has to some extent already been announced with emphasis in Europe more on fiscal consolidation rather than as in the U.S. on stimulus. At least two scenarios appear possible:
Benign scenario: Relative stability between the U.S. and the Eurozone will be maintained. This suggests that large persistent exchange rate fluctuations seem rather unwarranted and that eurodollar will unlikely move far away from its current trading range.
Adverse scenario: Perception of or actual sharp divergence in economic fundamentals between the U.S. and Eurozone materializes. This could result from sharply diverging monetary policy stances as during the early 1980s or due to exceptional circumstances like those surrounding the introduction of the euro (Chart 2). Negative surprises on sovereign indebtedness and/or growth seem to be the most likely source of possible adverse fundamental shocks. Uncertainty about actual exit strategies for monetary policies is another source of stress.
Emerging markets cannot be indifferent to persistent eurodollar jitters. Eurodollar will influence overall sentiment and is therefore likely to impact on broader parts of the global economy. However, emerging markets on average are today well equipped to withstand further adverse shocks. The global crisis has illustrated that most are apt to manage economic disturbances effectively. Subsequent shocks are therefore likely to be manageable as well. Under the benign scenario, emerging markets may simply pursue existing policies as any eurodollar-emitted shock is likely to be only transitory. Under the adverse scenario, some emerging markets may need to adopt policies to counter proactively possible negative ef- fects on their economies that may include reversing some of the policy tightening some have adopted. More fundamentally, persistent eurodollar jitters may be the best reason yet to abandon any dollar or euro peg.
Most emerging markets have maintained some form of dollar or euro peg. Persistent volatility in eurodollar now risks transmitting undue shocks to their own economies. The best policy response would be in many instances to allow the national currency to float more freely. This would isolate the domestic economy from possible adverse shocks of high eurodollar volatility. The transmission from eurodollar jitters to the domestic economy is of course complex and may materialise in channels other than the exchange rate. However, exchange rate pegs adopted to help stabilising domestic prices may now become a source of instability.
The importance of eurodollar jitters illustrates that the international economy has remained unduly dependent on just two monies. Emerging markets that depend less today on eurodollar may see this at last as an opportunity to seek greater domestic policy independence. The importance of eurodollar appears increasingly disproportionate to the actual importance of its underlying economies. Emerging markets today exhibit the necessary policy strength to shield themselves from advanced economies difficulties. For investors, eurodollar jitters may be the best reason yet to think beyond the dollar and the euro.