Despite the recent turmoil in foreign exchange markets, economists at TD Financial don’t believe that the G7’s communiqué calling for “more flexibility in exchange rates” will have a big impact. They say, however, that a major realignment in world currencies is necessary.

TD says that the recent G7 action isn’t a definitive stand against currency intervention, but was more likely aimed at China and various smaller Asian economies which maintain fixed or quasi-fixed exchange rates to the dollar.

TD says that the chief instigator of the drive for more flexible currencies has been the U.S. government, which is becoming increasingly concerned about its massive current account deficit. While the biggest currency movement since the announcement has been the yen strengthening against the U.S. dollar, TD says that Japan likely accepted the plea for greater exchange rate flexibility because the Japanese also understand the U.S. government’s primary objective to be an upward revaluation in the Chinese currency.

“The economic outlook for Japan supports this interpretation. Although the Japanese economy is currently experiencing a cyclical rebound, the improvement is still being driven largely by the export sector. That suggests that the Japanese government would be unlikely to agree to any strategy that would result in a unilateral strengthening of the yen versus the U.S. dollar — because that would imply a strengthening in the yen versus other Asian currencies,” TD says.

TD warns that a weakening in the U.S. dollar implies a strengthening in other currencies, and that could put a further damper on those countries’ exports, with negative knock-on effects on economic growth.

It also warns that the U.S. bond market is vulnerable to a falling dollar because Asian central banks have kept their currencies stable versus the greenback by purchasing vast quantities of U.S. dollars, which they have recycled into U.S. fixed-income securities. “This has been an important driver of the strong performance of the U.S. bond market this year, reflected in the remarkably low level of medium- and long-term yields. If the Asian currency bloc were to abandon foreign exchange market intervention altogether, this would result in a sharp drop in demand for U.S. fixed-income securities,” TD says.

At the end of the day, TD believes that the G7 agreement will have only a limited impact on the major exchange rates. “Given the importance to Japan of preserving the competitiveness of its export sector, we do not believe the Bank of Japan will stand for a further dramatic appreciation in dollar-yen. Accordingly, we think the most likely outcome is for the yen to establish a new, marginally stronger trading range. As for China, it has even more compelling reasons to preserve the sanctity of its fixed exchange rate.”

TD is sticking to its forecast that the Canadian dollar will end 2004 at US76¢.