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Tuesday December 6, 2005 - 13:01:33 GMT
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Forex: G7 Meeting Noted For What Was Not Discussed (Not A Concern)

It was not so long ago that G7 meetings were hugely important to financial markets and currency traders in particular. But G7 is no longer the event risk it once was as markets have moved on to far more diverse concerns like US Treasury long-term capital flow reports and the US Treasury semi-annual report to Congress on FX policies of major US trading partners. Indeed one has to hark back to February 2004 at Boca Raton to find any meaningful G7 meeting in the last few years. And before Boca one arguably would need to go back to the end of the Clinton presidency to find when last markets eagerly awaited the meeting communique and press conferences.

As it turned out G7 in London on Friday and Saturday was best known for what it did not say (about the yen and ECB rate hike) than what it did say (called on China specifically to move early to adopt a more flexible exchange rate).

Why was the weaker yen ignored? And if US Treasury Sec Snow was right about the need for more domestic-demand-led growth why did he not complain about the ECB rate hike last Thursday (first hike in 5 years). It would appear that the Treasury has its plate full worrying about the yuan and leaning on China to revalue than risk depleting international political capital and focus on a weak yen on top of a weak yuan (versus the dollar). Surely even with the bilateral trade gap with Jpn stabilizing in the last few years, policy makers like Snow need to be proactive. With G7 rightly concerned about risks of a disorderly adjustment in the trade account (sharp dlr decline derailing the global expansion), the Treasury should be doing all it can now to stimulate more foreign demand. Nothing on the yen, nothing on the ECB rate hike. Maybe Snow's calculus included a need to keep Europe on board in pressing China for a revaluation and criticizing the ECB rate hike would undermine that support. But he did say Europe and Japan needed to do more to boost demand. How could he not be critical of the ECB rate hike regardless of the need to speaks with one voice on China? I doubt the rate hike by the ECB will assure a stronger euro and hence the adjustment process is aided...not when the Fed has at least three more rate hikes before a pause and the ECB can't convincingly justify one quarter point rate hike after 5 years of stable to lower rates.

Moreover, Japanese officials were no sooner to sense being let of the hook on the weaker yen at G7 that they took to the airwaves to assert that the yen decline was warranted by economic performance and not a threat to the recovery/expansion. The BoJ too has apparently caved into pressure from Koizumi and company and has stopped talking about ending ZIRP and quantitative easing anytime even vague on it for 2006. Talk about a green light for selling yen. Adding to the yen sell-off was the extent that the US Treasury went out of its way to deny the Reuters wire headline on Friday that said Snow told the media the US would bring up its weak yen concerns at G7.

Since there is near unanimity of view that the US can't continue to grow on a foreign financed expansion without an adjustment, the question is whether that adjustment is orderly or disorderly. And in both scenarios a lower dollar is a key component of the adjustment. When I say nearly everyone agrees with this I mean nearly everyone - in and out of government. So while the Bush admin remains focused on China regarding FX, it will ultimately be forced to address other currencies that threaten a disorderly adjustment later if current trends are allowed to persist. Keep in mind too that the longer adjustment is delayed the greater the appeal of protectionist legislation to the likes of US Congress. I think by the February G7 meeting, we may be seeing a shift in how Treasury views the dollar...the longer adjustment is put off the more disorderly it will be when it hits. In this case some effort by G7 to talk the dollar lower should emerge.

Maybe by February markets will get a reminder of why G7 meetings can be important and command more attention from market participants than they have in the last nearly two years by addressing the need for an orderly dollar decline.

A failure at the Doha round of the WTO trade talks later this month in Hong Kong should stir concerns that the push to free trade and market liberalization is no longer desired, setting the stage for a cycle of protectionist trade practices where there are only losers. Perhaps this will be the wake-up call for G7 to return to the days of nudging the adjustment process in the right direction and a fresh approach will be taken at the Feb G7 meeting.

I have no illusions that at the end of the day it is private economic agents and their decisions that will drive the US external imbalance to adjust. But policymakers have a responsibility to nudge it in the right direction and try and encourage orderly adjustments over disorderly ones. At G7 there was little evidence suggesting G7 was up to the job.

I could be equally critical of US budget deficit "reduction" and lack of a policy approach to boost US savings (tax-based incentives) outside of Fed tightening as I am of Japan's de fact weak yen policy and the ECB's questionable desire to normalize rates in a period of uneven fundamentals. I will save that one for another day.

David Gilmore


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