G7 is Overshadowed

Another G7 meeting is upon us. It is the first such gathering since the market turmoil began and the acceleration of the US dollar’s decline. Some observers have suggested that it may be one of the most important G7 meetings in years. More likely though such hopes will be dashed and the G7 meeting will be overshadowed by two other gatherings, China’s Party Congress and the IMF meeting.

While G7 officials have no doubt been in communication about market developments, if there was going to be a coordinated response, surely we would have seen it by now, as most signs point to a gradual easing of pressures in the money markets, including commercial paper. Moreover, a G7 working group has been established to look at what lessons can be gleaned from the market turmoil, but an initial report is not expected before next month, with a final report expected next April.

There are two currency issues, the weakness of the dollar and the Chinese yuan, that will likely be discussed, but there seems to be little chance of fresh initiatives. The US dollar’s decline has been orderly and fundamentally comprehensible given the trajectory of interest rate differentials.

The euro’s rise has not crossed the ECB’s pain threshold. Some council members continue to highlight the benefits of a strong euro in offsetting the rise in oil prices. While the G7 will likely repeat its mantra about excessive volatility not being desirable, the fact of the matter is that implied euro-dollar volatility is easing after the late summer run-up. The standard 3-month implied volatility is near 6.4%, which is marginally above the 100 and 200 day moving averages (6.02% and 5.98% respectively) to put it in context.

Dollar Geometry

Many commentators do not seem to be aware that it took the Federal Reserve and the US Treasury nearly half a century to work out their quid pro quo on dollar policy. European economic and monetary union is not even a decade old so it should not be surprising that currency policy remains a bit of contested terrain in the euro-zone. Those observers that detect an intensification of official concerns about the strength of the euro mistakenly confuse the rhetoric of stakeholders, like French President Sarkozy and Finance Minister Lagarde and some exporters, with decision making ECB board.

Recall that all of plane geometry is deduced from five assumptions. For centuries there was some debate about the fifth assumption that parallel lines do not meet. Some argued that it might be able to be deduced from the other four assumptions. The most powerful proof that it was indeed an assumption was to assume the opposite, that parallel lines do meet. This produced non-Euclidean geometry, without which space travel, for example, would not be possible.

With some popular measures of the dollar, like the dollar-index (DXY) making new lows, pundits are having a field day making caricatures of US strong dollar policy. Yet it is not simply a hollow claim. This can easily be demonstrated by following the geometry example. That is to say proof of the substantive element in the strong dollar policy is to consider the impact if a US Treasury Secretary would say the opposite, such as “We have decided that US interests lay with a weak dollar not a strong one.” Is there any doubt that this would lead to a sharp dollar decline?

The dollar’s exchange rate, like the euro, is set in a free market. The bar for intervention is very high. In fact, US President Bush is on track to be the first president not to authorize intervention in the foreign exchange market in modern times. Some have suggested that the US might actually and quietly be welcoming a weaker dollar because it blunts protectionist sentiment. Yet there is no evidence that this is really the case. Indeed, quite the opposite has taken place. As the dollar has fallen in recent years, protectionist sentiment appears to have gotten stronger, not weaker.

China or Porcelain

The head of the Eurogroup of eurozone finance ministers clearly indicated that they were more concerned about China’s yuan than the US dollar and for good reason. In the first nine months of the year, China’s exports to Europe have risen by nearly 31%, almost twice the pace of exports to the US. Moreover, while the yuan has appreciated against the dollar (almost 4%), it has depreciated by almost as much against the euro. The US has also called on China to accelerate its currency appreciation. Chinese officials, just as clearly, say no thank you.

As good Marxists, Chinese officials have learned from history. It is the second Asian country in a quarter of a century to come under strong US-European pressure to dramatically revalue its currency. It is well aware of Japan’s experience and the economic havoc it caused. Chinese officials also appear to have learned from the Russian experience and the Asian financial crisis of 1997-1998. Neither the IMF nor the Washington Consensus have a track record that inspires Chinese officials. In addition, China’s membership in the World Trade Organization limits the potential protectionist backlash.

The size of the Chinese economy is set to surpass Germany’s this year to move into third place. The fact that it has yet to be invited to formally join the G7 is folly. The Chinese Communist Party Congress next week is arguably more significant than the G7 meeting. There will likely be two important economic appointments—the replacement of the trade representative who leads the delegation for among other things, the Strategic Dialogue Talks with the US, and who will be the next governor of the central bank. In addition, there have been some indications of the possibility of some political reforms. While there is no sign of the Communist Party giving up its monopoly on power, it is possible that President Hu introduces more intra-party democracy. Some contacts suggest the possibility that the groundwork is laid for some intra-party competition for some top posts, maybe even the presidency.

The IMF will also meet. Hopes of governance reform that would give some large developing countries greater voting rights looks likely to disappoint. It remains a US-European dominated institution that does not reflect the economics of the 21st century. It is simply audacious of the IMF officials to continue devising new mandates without governance reform. Without the cooperation of China and other large developing countries, its ability to monitor the foreign exchange market is compromised.

The G7 wants to talk about best practices for sovereign wealth funds, while the countries in which sovereign wealth funds are concentrated are not members and have few votes in the IMF. Moreover, the hedge funds, concentrated in the G7 countries, are nearly as opaque as most sovereign wealth funds, but officials have yet to agree on best practices for them.

G7 officials might be best served by following the biblical advice: “First cast the beam out of thine own eye; and then shalt thou see clearly to cast the mote out of thy brother’s eye.

The bottom line is that the G7 meeting is largely passé. There will be no intervention to stop the euro from rising or the dollar from falling. There will be more complaining about the speed at which China allows its currency to appreciate, but here too will be all thunder and no rain.