When it comes to foreign exchange, the G7 has been consistent over the past few years: exchange rates should reflect economic fundamentals and ‘excess volatility and disorderly movements in exchange rates are undesirable for economic growth’. In the wake of the violent moves seen in the foreign exchange over the past few months and in particular over the past week, the G7 statement is worth bearing in mind.

The question here is: have recent moves been excessive? The answer is yes. The three month volatility index on eur/dlr touched a high of 22.2850 in European morning session. This is significantly higher than the 12 level prevailing this spring, when foreign exchange intervention had been contemplated according to the Nikkei paper. The current volatility level is also significantly higher when compared to the level prevailing at the time of the last concerted central banks intervention (this included the Fed, the ECB, BoE, BoJ, BoC and the SNB) in October 2000 (the high on 3-month volatility was at 16.35 on October 27th 2000). From a volatility perspective, it is hard to argue the case against intervention.

Many other factors will have to be taken into consideration though. Firstly, this is not just a foreign exchange story: the sharp volatility of the past few weeks and soaring US dollar and yen result from continued de-leveraging in the banking crisis aftermath. This is accompanied by unprecedented volatility in the equity markets, a still extremely tight credit market and soaring government bond markets as risk adversity remains persistently high.

Secondly, while intervention talks referred to potential dollar buying a few months ago, dollar selling would have to be involved in the current instance. Recent movements have shown an increased positive correlation between movements in the dollar and volatility level. Another very important question is: would concerted intervention work considering that there is a shortfall of dollars in the world and given that the de-leveraging process will continue?

Intervention at this stage would most likely not trigger a change in trend, but it would at least contribute to stabilization of the market. And that would be consistent with the G7 logic: it is not the actual levels that matter; it is the excessive moves that can be problematic. It is also consistent with the provision of dollars via unlimited swap lines between the Fed and several other central banks.  An additional consideration is of a more political nature: after pressing Asia (and China in particular) over the need to adjust a more flexible exchange rate system over the past few years, intervention may question the initial G7 strategic signal. 

The scale of the recent currency moves will most likely rekindle intervention talks. When the US dollar and the yen rise by 6.7% and 12% respectively on a trade weighted basis just this month and when 3 month implied euro volatility is at its highest level since the European single currency was introduced, the G7 statement may be worth remembering.