G20: Little Room for Fresh Initiatives

Currency in Crisis

The G20 will meet in Mexico this weekend. There seems to be three key issues: IMF funding, replacement for Zoellick who will step down as head of the World Bank and the oil shock. It is unlikely that any of these issues are resolved this G20 meeting, but important groundwork could be laid for future decisions. 

The European debt crisis remains the most important issue. The euro area countries have committed about $200 bln, but want other G20 members to contribute. However, several G20 countries, including reportedly, the US, China and Japan want to see Europe do more to strengthen its own firewalls. In particular, this refers to strengthening the resources of the European Stability Mechanism (ESM).

At the end of last year, European officials postponed a decision until March. Germany though is pushing back against increasing the ESM. Unlike the EFSF, which is based on guarantees, the ESM is seeded with capital. The March 1-2 EU summit will likely see Germany come under more pressure, but without Europe doing more on that front, it is difficult to see much enthusiasm for more IMF funds. Of course, to the extent that a crisis in Europe threatens the world economy, it is in the self-interest of the G20 to assist Europe. 

Europe is the largest destination of Chinese goods and the slowing of exports to Europe is already evident in the data. However, the sense of urgency has slackened. The December LTRO and next week's has cleared reduced roll-over risk that seemed so overwhelming at the end of last year. The recent economic data suggests the euro zone economies are not accelerating to the downside. The EC called it a mild recession.

 The ECB rate cut that many, including ourselves had anticipated in Q1, is off the table. While unit labor costs are falling in the periphery, taxes are rising, budget deficits are falling, the collective current account deficit of the periphery has been nearly halved, the signs of adjustment from the creditor countries--Finland Austria, Netherlands and Germany (the FANGs, an acronym that has been coined) have barely made any adjustment. 

 In the US, with a true federal system, has seen a large drag from state and local governments that has been blunted, but not fully offset, but the expansion of the Federal deficit. Europe has neither the mechanism for this, nor the political will in lieu of the mechanism. The bottom line is that while there is some sympathy for Europe's straits, until they do more to help themselves, there will be a reluctance to see the IMF dramatically increase its exposure to it. 

The reason the G20 has replaced the G7 as the key international forum is that the former is more representative of the current state of the world economy. When it came to looking for a replacement for DSK at the IMF, Europe insisted on maintaining their privilege of naming one of their own as head. Traditionally, the US names the head of the World Bank. Zoellick has announced plans to step down near midyear. The battle for his successor has already begun. 

Of note when the IMF flap was taking place, Zoellick noted that any of his three deputies, all coming from emerging markets, would make attractive candidates. It is not clear that the Obama Administration is prepared to agree. The talk is that Hillary Clinton or Lawrence Summers are potential candidates. China is pushing for a more open contest, but it is not clear how hard it is pushing. It made similar noises before supporting Lagarde as DSK's successor. 

There is several months before a decision has to be made, so do not expect a resolution this weekend. However, the hallway conversations and the jockeying for position has begun. 

Lastly, the rise in oil prices pose the latest head wind for the world economy. Most of the G20 are net oil importers and in some local currency terms, including euro and sterling, oil is already at record highs. However, while the embargo against Iran and its retaliation is a supply shock, the larger driver of higher oil prices seem to be the political risk premia on fears of a larger disruption. 

It may be too early to expect G20 officials to coordinate a draw down of strategic reserves. Yet the reason for the strategic reserves is to be in a better position to address precisely these kind of supply shocks. The beginning of the talks to coordinate the response is likely this weekend. 

With the ECB's Draghi talking about recent data suggesting the area's economy may be stabilizing, and the US likely to announce an upward revision to Q4 GDP data next week, the rise in oil prices could be the single largest risk to growth. 

Increasingly it looks as if the central banks easing operations are set to pause. The latest phase began late last year with lowering the cost of dollar swaps and the LTRO and BOE gilt purchases, ECB two rate cuts and Operation Twist in the US, and China's first RRR cut. These have been followed this year by BOE new gilt purchases, BOJ expansion of its asset purchases, another RRR cut by China and the Fed pushing out until at least late 2014 its first hike, and next week's LTRO likely concludes this phase. Higher oil prices complicate the economic outlook and scope for central bank action, especially among those areas, like the euro zone, where officials typically emphasize headline inflation.