At G7 Dollar and Yen Take Back Seat to Financial Crisis and Economic Slowdown

While G7 moves ever closer to the totally irrelevant in the realm of international economic policy deliberations, I am yet again compelled to write about this growing irrelevancy.
While G7 moves ever closer to the totally irrelevant in the realm of international economic policy deliberations, I am yet again compelled to write about this growing irrelevancy.

It is no mystery that the financial crisis (it is a crisis despite official Orwellian spin – financial turmoil) and global slowdown trump currency concerns. But like the usual currency concerns, there is not much G7 is willing or capable to do to prevent a serious slowdown. Credit markets are tight and no amount of easing will alleviate this condition until markets are confident that credit has been adequately repriced and counterparty risk fully exposed. This could take the better part of the year to sort through as the pipeline of write downs at the banks remains full – CMBS, leveraged loans, Alt-A, HELOCS, option-ARMs and plain vanilla loan defaults that go with economic slowdowns. The Fed, EC and BoE can keep banks full of cash (liquidity) but can’t do much about confidence in the financial system and amongst financial intermediaries. So far G7 finance ministers have been even less successful addressing the credit crisis than the central banks. US Treasury’s M-LEC or super SIV comes to mind as does the HOPE Alliance. Moreover the latest US fiscal stimulus achieves nothing when it comes to credit. Canada’s SIV program is just slightly more successful – actually launched though less clear that the paper it is issuing is drawing much demand. And there is talk of a European bank super SIV already up and running (clandestinely). Meanwhile G7 has turned the monoline rescue over to state officials like the NY state insurance commissioner, though Bernanke this week wrote in response to a question from a member of Congress that the Fed is closely following the bond insurers. Treasury spokesman too admitted this week that the Treasury is in touch with the rating agencies. While many think MBIA and or Ambac are going to be downgraded, I think this is about as likely as the housing market recovering. A senior official at Moody’s this week said the reason the rater was taking so long to issue its decision to downgrade or not to downgrade was because it wanted to make sure it got it right. And Imelda Marcos had so many shoes because she walked a lot.

Back to G7…

Apart from Paulson and Bernanke explaining why monolines won’t be downgraded, what can we expect on FX and monetary and fiscal policy coordination?

On FX Europe and Canada are now more worried about the weak US$ than at any prior meeting in light of the very obvious US economic hard landing. Not even the bounce in the dollar in the last week will buy much relief for the vulnerable European and Canadian economies…which remains at odds with the ECB’s inflation obsession that a strong euro squarely confronts. And from the US perspective why would Treasury contemplate any new FX language calling for a stronger dollar when the main offset to weak housing has been and continues to be exports? Japan too is not inclined to embrace European and Canadian calls for a higher yen and burden sharing with its export sector, like Canada, France and Germany’s exports, softening on weaker US demand.

So the lowest common denominator remains the yuan and even this argument is losing traction as China has adopted a slightly faster pace of appreciation since late in 2007 and as the dollar begins to firm (for G7 ex-US). So it is almost certain that the G7 communiqué Saturday will read much like the statement from the October meeting.

In terms of monetary and fiscal policy coordination, it is also clear that what is good for the goose may not be good for the gander. Massive monetary and (somewhat less so) fiscal stimuli are good for the US and not good for the rest of G7 – that is what Paulson will hear this weekend. So far Paulson has only called for domestic stimulus measures in Japan – presumably fiscal ones as the call rate target remains at a low 0.50% and any cut here would be an admission that deflation and stagnation has not departed despite the quantitative easing through 2006. Trichet will be more on the hook to deliver US-led rate relief in Europe that the Bank of England and Bank of Canada have embraced albeit more measuredly. Based on Thursday’s press conference performance Trichet and the ECB council are coming around to the real economy impact from the credit crisis, record oil, weakening US consumption, foundering global real estate markets, weakening equity prices and collapsing firm and household confidence. I think Trichet’s ECB will be cutting sooner than later and would not rule out a March cut, though April seems more likely as the SS ECB ship turns more slowly.

Last oddity is that the US is spearheading an effort to make the IMF relevant in policy currencies (over and under valued) and currency regimes. Part of this Monty Python sketch quality is due to the fact that the IMF has thousands of employees and only two active programs – Turkey and Argentina. It needs to do something. But this is like asking the UN peace keepers to prevent the massacre at Srebrenica. The IMF has no authority and is thoroughly under gunned when it comes to affecting currency values much more currency regimes.

One international economy development that bears watching is the Senate Finance and Banking committees are pressing ahead on a new currency policy bill – call it the yuan bill – despite pressure from Paulson to delay any new trade/FX legislation. As populist political trends take root in both parties ahead of the November 2008 elections, there is every reason to look for the US Congress to a trade battle if not war with China over the yuan and this will heighten risks to growth and US rates (what of China stops buying Treasuries) in the coming months.

David Gilmore