What Not to Expect from the G7 Meeting

The weekend G7 meeting is unlikely to generate fresh policy initiatives or inject a new force into the foreign exchange market. Indeed with concerns that the world’s biggest economy has begun contracting and as the world's second largest economy stumbles and the third largest economy slows, the foreign exchange market itself may not receive the attention it may have in the past.

Consider what has happened in the forex market since the G7 met last on Oct 19. The Chinese yuan has appreciated by about 4.5% since then which clearly represents an acceleration of the pace. Despite the aggressive Federal Reserve rate cuts, the euro itself is only marginally higher than the $1.4300 area that it was trading around on the eve of the last G7 meeting. After peaking in late Nov, the euro has trading in a broad $1.4300-$1.49 trading range more or less since. The UK has begun its own easing cycle, with another move highly likely to be delivered tomorrow, on the eve of the G7 meeting. Sterling is trading about a dime (10 cents) lower than it was before the previous G7 meeting.

The Canadian dollar peaked a couple of weeks after the mid-Oct G7 meeting and is more than 3% weaker now. Like the Bank of England, the Bank of Canada has begun to cut interest rates--twice since the G7 meeting and will likely cut rates again next month.

The yen has advanced around 7% against the dollar since the Oct G7 meeting. This gain does not reflect improved Japanese fundamentals. On the contrary, the mostly disappointing economic performance has seen the market give up on ideas that the BOJ can hike rates any time soon. There appears to be some chance (maybe 1 in 4) in the overnight index swaps market that the BOJ has to cut rates. Since then, the plunge of global equity markets and turmoil in the credit markets has encouraged the unwinding of carry trades. In the middle of Oct, for example, the speculators (non-commercials) at the IMM had a net short yen position of about 38k contracts. The most recent data shows the net spec position is now nearly 53k long.

The G7 cannot be that unhappy with currency market developments since they met last, though of course China will likely be encouraged to continue its progress. Two other issues look to overshadow the foreign exchange discussions. One is whether new rules and regulations are needed in the capital markets. Germany appears to be taking the lead in this area, but a consensus has yet to crystallize and probably won't until at least the April G7/IMF meeting.

The other issue is how to respond to the economic headwinds. The US position is clear. Through various administrations, the US has consistently argued from a pro-growth vantage point. It has, for instance, maintained that the world does not suffer so much from the US trade deficit as a growth deficit in ROW (rest of the world). Senior US Treasury officials have called for countries to take "prudent steps" to ensure that economic expansion continues.

The head of the IMF Dominique Strauss-Kahn lent support to the US position when he suggested that temporary tax cuts ought to be considered to boost the world economy. The US is not the only country to be looking at some sort of fiscal stimulus. Canada's minority government has already offered subsidies to some local areas and there is pressure to do more. Recall that Canada is the only G7 country with both a current account and budget surplus.

The UK's Chancellor of the Exchequer Alistar Darling has indicated that fiscal policy will be in support of monetary policy. And even if this does not point to increased spending, tax hikes, which some have suggested are necessary to meet fiscal objectives, are unlikely to be implemented. Japan's Finance Minister Fukushiro Nukega seemed to suggest that Japan was not so supportive of fiscal stimulus, but Prime Minister Yasuo Fukuda has pulled no punches to ram through the FY08 budget and has made shallower cuts, for example, in public works spending and the monetization of the government's debt continues with large coupon purchases (rinban operations). France and Italy also seem to favor fiscal stimulus, with both the failed Prodi government and its likely successor supportive of tax cuts.

G7 statements tend to paper over whatever differences there may be. This meeting should not be an exception. The biggest challenges to the world economy might not able to be resolved by coordination. Countries are in different places in the business cycle, but to suggest as Germany's Deputy Finance Minister Thomas Mirow has that the crisis began in the US and is the US responsibility to address seems to miss the point. The real point is that the world economy is slowing, that the expansion cycles are past their peak and that even in Europe, the expansion produced excesses. Risk is being reassessed globally. Flash back to 2000-2001 and in 1997-98 and the early 1990s and one would find a similar thrust to European views. The aggressive pro-growth stance of the US offers stark contrast then and now, but expect the G7 to resolve it. By the April G7 meeting, the slowing of the euro-zone will be less deniable than it is today and by the economic summit a few months later, the ECB will likely to have cut rates.