ECONOMICS

AND THE CITY

Sterling in the money market

Tim Conway

Flexible exchange rates and flexible interest rates are two sides of the same coin. To have one without the other makes both the conduct of international economic relations and domestic monetary policy impossible.

This must be the most important lesson of the past few weeks in the foreign exchange markets. On fundamentals — or, to be more explicit, the British balance of payments — sterling should be very weak at present and should have been so for at least six months. In fact, it does not stand much lower against the dollar than it did last October, while, against other currencies, it has been within a band of 17 to 20 per cent devaluation on the December 1971 Smithsonian parities since last August.

csut there were good arguments against the pound being allowed to fall further. It is one thing to let the free play of market forces push and pull the exchange rate in response to marginal adjustments in international competitiveness, but quite another to see it being bounced up and down like a yo-yo as traders go in and out of a very thin market.

As the use of one instrument for attaining equilibrium was prohibited by these considerations, another — interest rates — had to be adopted. On November 13 last year Minimum Lending Rate was jacked up to 13 per cent, much to the dismay of jobbers in the giltedged market and the chairmen of building societies. This move inaugurated a period of dear money which only now shows signs of coming to an end.

These signs have been obvious enough. On Friday the week before last Minimum Lending Rate was cut for the third successive time to 121 per cent. On Wednesday morning last week the clearing banks lowered their base rates from 13 to 121 per cent, an event celebrated by the Evening Standard in banner headlines which proclaimed that the cost of borrowing was coming down. This must have startled its readers as they read the not very fine print which talked of interest rates more than double those to which most of them had been accustomed for the greater part of their working lives.

But is it possible that even these reductions, which only nibble at the problem, are a false dawn? Why have interest rates begun to come down, and are the causes permanent and reliable or temporary and insecure?

If interest rates rose in the autumn because sterling threatened to be weak, they have started to decline in the spring because it showed uncanny symptoms of remarkable strength. Throughout February and March it had been gaining ground against the dollar, first rather uncertainly and then with gathering impetus.

This took many people by surprise, particularly when it coincided with monthly gold and foreign currency reserve figures which showed that the Bank of England was clearly not straining every muscle to engineer an appreciation in the rate. Who was buying sterling, and why?

There were two kinds of people, apart from traditional operators and foreigners buying British currency to pay for British exports. The first were a number of international banks financing large Eurocurrency loans for nationalised industries and local authorities which have Treasury blessing for their international fund-raising activities.

But the second group of buyers, and quite possibly the more important, were about half a dozen oil-producing countries, flush with dollars from the first batch of payments from the oil companies since the price rises in October and December last year. As former members of the sterling area they regard the City of London as the most efficient and convenient piggy-bank they have. Their first reaction, therefore, was to buy short-term money market liabilities and government securities denominated in sterling or to deposit their rapidly increasing wealth with merchant banks, like Morgan Grenfell, who have been their financial advisers for many years.

They were encouraged in this by two factors, both probably of a transient nature. Politically, most of the Arab states have to put up a pretence of disliking the United States and its most pervasive economic emblem, the dollar. Financially, they must have seen that the exceptional interest rates in London over the new year made it quite an attractive bolthole for their funds and that

capital lOsses, because of still higher rates, were less likely than capital gains. In this they forgot the investment habits of the English middle-class The important question, therefore, is: will the oil-producers keep their funds in London now that interest rates are starting to decline? There are a number of reasons for thinking that they will not.

The globe-trotting of Henry Kissinger and the Harvard Business School backgrounds of personal assistants to the Arab finance ministers will probably combine to weaken the political objection to investment on Wall Street or, at any rate, in dollardenominated assets in the Eurocurrency markets.

More significantly the Federal Reserve Bank of New York has clearly been given instructions that the control of inflation in the United States is its responsibility. President Nixon has abandoned the panoply of price and wage controls which had been his administration's main weapon against rising prices since the inception of the New Economic Policy in 1971. Following this crucial change in strategy, the conventional tactics of monetary restraint are being used. Restrictive open-market operations are obliging the major US banks to raise their prime rates and, in a number of cases, these are now at 10 per cent.

Rates in the Eurodollar market are linked to those in the domestic US money markets. This is one of the few remaining cases in economic affairs where the dog wags the tail and not the other way round. Even if the Eurodollar market is on the hundred billion dollar scale, the money market in the US itself is four or five times as large. Hut, as Eurodollar rates rise, the scope for some reduction in Eurosterling rates and, ultimately, British domestic rates, is eliminated. A rather unholy alliance of Arab oil sheikhs and the finance directors of multinational companies will switch funds and sell sterling for dollars. The Bank of England will have to stem this either by guaranteeing yet more borrowing by UK public authorities or by making sure that interest rates in London are realistic and competitive.

The implications are twofold. First, any substantial easing of interest rates in England is unlikely while the American government is relying on monetary policy to control inflation and the British payments deficit is huge and growing. Second, the problems of the building societies and other financial institutions can only be solved on something more than a handto-mouth basis when the balance of payments is improving and sterling can stand on its own two feet, without being propped up by "outrageous, dangerous and destructive" interest rate levels.

Nicholas Davenport, who is ill, hopes to resume his articles next week