G20 Post-Mortem

The G20 meeting did not provide much in the way of fresh trading incentives. However, there were a couple of developments that were noteworthy.

The most important of these is the balance struck between growth and fiscal austerity. Ahead of the meeting much was made of the different directions that the US and Europe appeared to be headed. The US emphasized the need to ensure that the recovery becomes entrenched before taking away the punch bowl. European officials emphasized restoring investor confidence by regaining control over fiscal policy to ensure stronger growth.

While there may be underlying differences, the rhetoric probably exaggerates the significance. Outside of the periphery and the UK, the core in Europe, like Germany and France, are not really tightening this year. What they have announced, for the most part, are multi-year intentions.

For its part, the US is not as blind to the need to the need of fiscal reform. The Obama Administration has proposed a 3-year freeze on non-security domestic appropriations, for example. The fiscal from state and local governments in Q1 10 was about 0.5% of GDP and as many of their fiscal years begin 1 July, more tax hikes and spending cuts are likely to be delivered. In most of the monthly employment reports, the loss of jobs on the state and local government's more than offset the hiring of census workers.

The circle was squared by the G20 through adopted quantitative targets. It was agreed to cut budget deficits in half by 2013 and to stabilize debt/GDP ratios by 2016. These targets seem reasonable. Here growth will help. It will reduce counter-cyclical spending and boost revenues.

That leaves the structural deficit--which is the deficit that is expected if the economies were at full employment. The IMF warns that without action, the US structural deficit would be 6% of GDP in 2015 and the euro-zone's closer to 4%.

A second noteworthy development from the G20 is the acknowledgement that banks will have to significantly raise capital. New Basle rules are expected to be finalized by the end of this year and phased in by the end of 2012. While demand may not be strong, there does seem to be a supply-side issue too as banks seem reluctant to lend--throughout the developed countries. Part of the reason could very well be the regulatory uncertainty about how much capital is needed.

The third development is something that did not take place. China's move a week before the G20 meeting, endorsing a more flexible currency--seemed to have successfully deflected attention. How far and fast the yuan moves is still an open question. The 12-month NDF implies around a 2% appreciation of the next year, which is unlikely to impact trade or investment flows significantly. The US (and others) mean by a flexible yuan is that the government stops restricting its appreciation. To Chinese officials a flexible yuan means a currency that moves in both directions, but in a well defined range.