Of all the international financial markets the most difficult for economic forecasters to come to come to grips with are the foreign exchanges. This is
Largely because they are often driven by political factors rather than changes in the real economy, and they have proved more responsive to coordinated action by Western governments than equity, bond or commodity markets.
The foreign exchange markets are currently going through one of those periods when conventional wisdom is turned on its head. The historically weaker currencies in Europe -- Sterling, the Italian lira and the Spanish peseta -- have been extraordinarily strong, whereas the stronger currencies of recent decades, the German mark and the Japanese yen, have weakened against their European counterparts and the US dollar.
These developments have played havoc with the business community. No sooner had Japan begun moving a great deal of its industry offshore to cheaper production areas in the Pacific and Europe than the yen has fallen on the foreign exchanges, making Japanese exports competitive again.
The airline industry is not immune. A strong dollar increases costs since many major items, including the price of fuel, new equipment and spare parts, are priced in the US currency. Carriers can benefit, but only if the cost increases can be offset against dollar revenues. Thus the main winners are the US majors and carriers like British Airways which have strong dollar revenues.
However, the current new order of currencies may provide a temporary boost to carriers like Lufthansa and Japan Airlines, which have been undercut by airlines with weaker home currencies.
Two separate factors have driven the present currency inversion. The first has been the concerted effort by the seven largest industrial economies to reverse the decline in the US dollar. The second has been the faster than expected drive this year towards the goal of European Monetary Union (EMU).
To understand the change in the value of the dollar vis a vis the currencies of the US's trading partners one has to go back to April 1995. It was then that finance ministers and central bankers from the G7 largest industrial countries decided that the fall in the US dollar to its lowest level since the second world war had gone too far and needed to be reversed. In particular, the sharp decline of the dollar against the yen threatened the global recovery by rendering the Japanese economy totally uncompetitive. In order to reverse the dollar's decline G7 took two steps: it told the foreign exchange markets that it believed that the dollar's decline had gone too far, and it reinforced this statement with joint intervention -- by all the main central banks -- to reverse the trend.
The timing was generally good. Instead of challenging the G7's judgement the markets basically agreed that the dollar was too weak. After all, the US authorities had halved the size of the US budget deficit, delivered sustained non-inflationary growth, and even managed to narrow the gaping trade deficit.
As a consequence of the G7 action the US dollar this Autumn is 34 per cent higher against the Japanese yen, a dramatic change in the relative fortunes of the two currencies, and almost 10 per cent higher against the Deutsche mark. The IMF has attributed this strengthening of the dollar to higher interest rates in the US compared to those in Japan and Germany, as well as the continued good health of the US economy.
The IMF now takes the view that the dollar's exchange rate against the currencies of Japan and Germany is more consistent with economic fundamentals than has been the case for some years. That does not, however, mean it will stay where it is. The US administration is coming under increasing pressure from US manufacturers and service providers to unpick what they see as an uncompetitive value for the dollar. Now that the US elections are out of the way there will be less concern in Washington about upsetting allies and more about sustaining domestic US growth, which may mean allowing some depreciation in the US currency.
The second event which has triggered exchange rate reversal is the drive towards the exchange rate mechanism. Since the Dublin summit in September 1996 there has been an increasing conviction on the foreign exchange markets that monetary union will take place at the end of 1999. This ironically has led to a flight of money out of the core currencies which are likely to qualify for EMU, notably the German mark and the French franc, to the peripheral currencies which are less likely to qualify for the first wave.
The biggest beneficiary has been Sterling. It has climbed more than 8 per cent against a basket of the currencies of the UK's main trading partners and now stands at its highest level since December 1994.
Several special factors are acting in the case of the pound. Of all the 'out' countries, the UK's economic performance will be closest to those inside, so that its higher interest rates look particularly alluring. The spread between UK and German rates has increased by 0.6 percentage points this autumn. The pound also has benefited from the 25 per cent rise in the price of Brent crude oil since July, which benefits the country's balance of payments.
It is reasonable to expect that the strengthening of the dollar and other European currencies against the German mark will be sustained over the next few months while the Germany economy struggles to lift itself out of slowdown. Once that has taken place, however, the mark might begin recovering. As for the dollar, it is almost certainly close to its peak against the Japanese yen.
Alex Brummer
Source: Airline Business
