Julian Callow

3 JULY 2007

  Q60  Lord Cobbold: I wanted to ask about the exchange rate at the moment and whether you are concerned about the possibility, what we see is going on, of reserve diversification, the huge reserve holdings of the Chinese and the Japanese, in predominantly US dollars, whereas the US dollar is weakening, with their selling and buying the euro, and that is affecting the euro exports to the United States, among other things, and is this a serious problem which is going to get worse?

  Mr Callow: I think it is a serious problem. The Chinese current account surplus has been literally exploding and last year was a little above 9% of Chinese GDP. This year it could get to around $400 billion, which would be 12 or 13% of Chinese GDP, based on information which is currently available for the first half of this year. Last year the Chinese current account surplus was $249 billion. In the case of Japan, the current account surplus is also rising rapidly and this year could approach $200 billion, and the rest of Asia, apart from China and Japan, is likely to have a current account surplus this year of some $130 billion. If we put all this together, 130 plus 200 plus 400, you can see that we are getting, for Asia, an aggregate current surplus of $700 billion to $800 billion, which is a tremendously large surplus for one region to be having, and its counterpart is the United States, generally speaking. It is clear that in the case of China the size of the current account surplus is creating particular pressures for controlling the supply of money in the economy, and therefore for controlling economic balance and particularly inflation, and therefore the Chinese authorities are responding by having a very gradual appreciation in their currency. What has happened has been a tremendous rise in Chinese competitiveness, brought about by such heavy investment, which really dwarfs any kind of braking effect and dampening effect which might come about from having some minor currency appreciation. Of course, Chinese trade, its exports to Europe are growing at least as fast now and are of a similar magnitude as they are to the United States, so I think this is putting a lot of competitive pressure on the European economy, for one thing, and then there is this issue about the diversification of the FX reserves, leading to some upwards pressure on the euro also. In conclusion, I have given you quite a lot of numbers but I think there are some very substantial risks associated with this. One is the fact that China has invested so heavily, but, by increasing rates of intervention, has been keeping its exchange rate fairly constant. Really one can argue that it is warranted for it to have a significantly stronger exchange rate now, proportionate to its improvement in competitiveness.

  Q61  Lord Cobbold: Is there any scope for putting a bit of European pressure on the Chinese to gently up-value their currency?

  Mr Callow: I think there is some pressure going on, but Europe, of course, I think I hardly need to say, tends not to be particularly co-ordinated on matters concerning the exchange rate, particularly when we compare it with the quite uniform position which the US Treasury will take often, in conjunction with the US Federal Reserve system. Therefore, it seems to me that Europe is agitating but in a very polite way, which means that the bulk of the attention and the pressure that is noticed out of Beijing will tend to be vis-a"-vis Washington. I think that things have been changing so much that there is a strong argument for greater dialogue between Europe and China on this matter. I think it is very important to realise that there have been a lot of economists who have tried to argue in the past that the Chinese authorities do not need to have a significant currency revaluation, but the current account surplus, even if we go back two or three years, was a much, much smaller proportion of Chinese GDP, just a few per cent of GDP, compared with the situation which has happened now, so things have changed very significantly. I think actually where Europe might be most effective is in seeking to have China see a higher level of domestic consumption. The household saving ratio in China is around 40%, which is very, very high because there is not an effective welfare system in place, and therefore China is moving in this direction. If it can create a high level of security among households, through some development of its social security framework, then I think this would serve to lower such a high household saving ratio, and in turn that would go quite a long way towards redressing this very large imbalance.

  Q62  Chairman: I am sure it is a worry and I am sure that Europe negotiates in a rather complicated way. I am trying to get us back to what difference does the euro zone make in this? Would it be an appropriate role for the Central Bank to go and nab China's central banks, for example; or is that not how it is done? Does the presence of the ECB give them, as it were, a word to say in this debate?

  Mr Callow: In general, it seems at the international level, matters concerning exchange rates really are led by finance ministries and therefore are not traditionally the preserve of the Central Bank. In the case of monetary union in Europe, I think there are particular ambiguities in this relationship. This is partly because in Germany there is a long history of leaving exchange rate matters to the Bundesbank, by the Finance Ministry, but that has not been the view adopted by other countries, and therefore there is a clear sensitivity on this point. The ECB exists, and I am sure it does seek to give a view here. It is clear that Mr Trichet, the ECB President, does refer to the need for exchange rates to reflect fundamentals, and China has been mentioned sometimes in this respect and Asian countries in general. I think, as well, really this initiative needs to come from the finance ministers but then you have the issue of the Eurogroup and how strongly they can enforce a view.

  Chairman: I think I may be going down a blind alley there.

  Q63  Lord Inglewood: Can I first ask a question, as I understand it, which Lord Kerr put to you, which strikes me as being interesting. I thought you said it was your view that the existence of EMU was something which had driven forward London's financial position, taking the world as a whole, and so there is a direct correlation between London's pre-eminence in various areas and the introduction of EMU. That was what you said: yes?

  Mr Callow: Yes, I would agree with that.

  Q64  Lord Inglewood: If I might, on a more sort of general point, we have a Stability and Growth Pact, which is the framework for the single currency: do you think that is the right sort of framework for such a project? In a more particular way, if you go back to the recent reforms of the Pact, do you think they were about right, or they go too far or not far enough, or what?

  Mr Callow: As we know, there was a reform a few years ago of the Stability and Growth Pact which was designed to make it more flexible, less mechanical, in its implementation, and in particular to give more discretion for the implementation of pressure if excessive deficits are identified. So far, I think, the revised Stability and Growth Pact has been performing well; in particular, we might observe that the deficit of the euro area General Government sector for this year is likely to be below 1% of GDP, and last year it was 1.6% of GDP, which is certainly a low ratio compared with ratios of a little below 3% of GDP, for example, in the United Kingdom. Therefore, it seems that, so far, there has been good intent which has been executed soundly within the Stability and Growth Pact, and I think one can identify here particularly the way that Italy, Germany, Greece and Portugal have turned their deficit ratios, which were well above 3%, down to ratios below 3%. In the case of Germany, this year, the General Government deficit might even be zero, on current trends. It has to be said that we have been living in an extremely benign time. Over the last four years we have had global economic expansion which has been well above trend. Really you have to go back to the early 1970s to find global expansion so rapid in the global economy. In particular, there have been some very pleasant surprises, with fiscal revenues being much stronger than expected, in recent years. The climate has been very helpful for a reduction in budget deficits. The Stability and Growth Pact does rest very heavily on peer pressure; really it is a club of finance ministers, deciding among themselves on the appropriate action, and so far that has worked well. Germany has very nobly taken the lead itself in bringing down its deficit, and in Germany it is clear that there has been strong cross-party consensus for achieving that, and strong opinion within Germany on the need to lower its deficit. Italy has also been successful; and Portugal, in particular, has seen a considerable sacrifice of economic expansion because it has been cutting its deficit. So far, so good, but if there were to be a particularly grave economic shock then the question which still arises is how committed governments would be towards fiscal restraint, particularly, of course, if that shock were applying to a particular region.

  Q65  Lord Blackwell: As you said, the euro has operated so far in a fairly benign economic climate, low inflation, and you mentioned earlier that in that environment real interest rates had been quite low. Do you worry at all about, if we do have a period of shock, whether the ability to sustain that same interest rate over what are still quite different economies will cause problems, even if they manage to contain their deficits, and do you think there is enough capital and labour mobility to underwrite maintaining that similar currency area and single interest rate?

  Mr Callow: I think the challenge which central banks face in general, and certainly this is true for the European Central Bank, as the Governor of the Bank of England, Mervyn King, has identified, is that we have lived through a very benign period on inflation and that has had the effect of keeping inflation expectations low and relatively stable. At the same time, we have been seeing rising pressures in global commodity markets in recent years, and the global economy is in a mature phase and increasingly in a resynchronised phase of expansion, which means that inflation pressures may become more prevalent, which could cause inflation expectations to shift higher, which would mean then that central banks would have to start to get much tougher than they have been. In a way, you could argue that central banks have been coasting a little bit on the tail-wind of their previous tough policies, which were implemented in the 1990s, so far this decade; they have had a relatively easy ride, which means that they have been able to keep monetary policy a little bit on the accommodative side, but things may start to get tougher. In the case of the ECB, that is going to raise some important challenges. I think the most important issue is I do not believe it to be agreed unanimously across Europe that the Central Bank has to set an inflation rate as its primary objective. Clearly, in some political circles, there is the view that there should be some trade-off between inflation and growth objectives, even though modern economic thinking tells us that growth is a very important determinant of inflation, so really you cannot focus on an inflation objective if also you are pursuing a growth objective. A particular pattern of growth will lead to a particular pattern for inflation. As the European Central Bank raises interest rates further I think there will be pressure on it from politicians, who feel that it should be starting to pay more attention to growth and who will question its independence. That is perhaps the most significant challenge, as I would see it, that the European Central Bank is likely to face. As well, things may look good in aggregate, stable, there has been good progress on the deficit side, as I mentioned, inflation rates are broadly fairly similar across the euro area, but there have been some tremendous differences in the economic performance of manufacturing sectors across Europe. In the case of Germany, we have seen what is really a tremendous improvement in competitiveness and in productivity and this has led to Germany having an ever-rising current account surplus and German companies advancing in market share within Europe. Whereas, at the same time, in Spain we have seen a very large widening of its current account deficit, and that is connected with the fact that in Spain the share of construction in GDP is now 18%, which is very, very high. You might think that a more normal ratio might be ten or 12% for this. We have some very substantial imbalances across the Euro Area; in a sense, they are starting to resolve. I think now we look at a horizon where, in Germany, consumption can improve, there is more jobs' growth in Germany, so Germany starts taking back some of the dividend which has been accumulating from its restructuring efforts. That, in turn, means that if Germany is expanding more significantly it may have slightly higher inflation, and that will mean that countries like Italy and France and Spain will need to have low inflation to keep the average inflation rate in line with the ECB's target. This really, I think, is the second related challenge which will be presented by the European Central Bank.

  Q66  Lord Blackwell: Presumably, given that different economies, you said recently, will have very different exposure to imported commodity inflation, different dependence on oil, different dependence on construction versus other services, this could lead to situations where, if you like, a fit for each country, monetary policy could be very different. Without labour or capital, well, capital mobility, I guess you would probably argue, is adequate, but without labour mobility is that sustainable?

  Mr Callow: Yes. I think, on labour mobility, I noticed the European Commission had reported that in Europe this is about half of that across the United States. For example, in the ten years to 2001 only 4.4% of EU residents had moved to a different country, and only 21% had moved region within their country. In Italy, last year, the unemployment rate in the north was 3.8% and in the south it was 12.8%, which provides us with some powerful evidence that there was not a strong movement within Italy itself. Even for a country which is not particularly large, in a geographic sense, like Belgium, you can find differences in regional unemployment rates which seem quite significant. To my mind, the labour mobility issue is reflecting the fact that is partly cultural but partly the generosity of social security systems, which mean that the financial incentive to move region in Europe is significantly less than it is in the United States. Therefore, this does mean that if a region has lost competitiveness and it is slow to wake up to the fact, and I think there is evidence to suggest that can happen, then it is going to be set for a much weaker period of economic activity. We have the example of Portugal, which has had weak growth and fiscal consolidation, so Portugal, I think, shows us that tough measures can be undertaken, but it has been a considerable strain, I think, for the Portuguese Government to achieve, and even now one could say that it is not completely in the clear with its adjustment. In respect to your question then there are going to continue to be problems associated with differences in interest rates not being appropriate by region. Against that, I think we have to say that this argument obviously was being made before monetary union, and I think one could say, if I may, that monetary union probably has proceeded in a more benign way, as we look at it nine years on, than might have been expected in the light of all the many shocks we have had, particularly from energy prices and currency volatility. Certainly there are going to be considerable challenges ahead, particularly if central banks have to start getting a bit tougher on the inflation issue.

  Chairman: Thank you very much, Mr Callow. As often happens to us, with a knowledgeable and experienced witness, we have run out of time. If you have got anything in writing we should be terrifically pleased to receive it, because you have been most helpful and given a very clear banker's view, from somebody based in a sterling area, which is extremely important to us, it gives you a slightly different view on the euro. Thank you very much indeed for coming; it was very good of you.