Global Trends by Martin Khor

Monday 15 November 2010

Inconclusive G20 summit, amidst new Europe crisis

The G20 Summit last week ended inconclusively, and it was overshadowed by a new financial near-crisis in Europe, highlighting the dangerous state of the world economy

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The world economy remains in a web of serious problems with the potential to break out in new crises.  The G20 Summit last week discussed them but could not agree on the causes or how to resolve them.

Even as the G20 leaders were meeting in Seoul, the real drama was taking place half a world away, as Europe stood on the brink of a new financial crisis.

Ireland faced a big jump in the interest cost of its debt, arising from (and giving rise to) fears that it would have to be bailed out, like Greece some months ago, or even face a debt default. It seemed like the investors' loss of confidence crisis could also spread to Portugal, Spain and Italy.

It took a hurried joint statement by five European finance ministers, issued in Seoul, that holders of present European governments' bonds would not be asked to share the burden of bail outs, to calm the markets last Friday.

But it remains to be seen if there will be new turmoil in Europe in the near future, as many analysts are of the view that the sovereign debts of several European countries are unsustainable, that they would need a bail-out by the EU and the IMF, or undertake debt restructuring, or both.

In the 1990s it was Asia that faced a debt crisis, and in the decades before that Africa and Latin America.  In recent years, East European countries were affected.

But until just months ago it was inconceivable that a sovereign debt crisis would ever hit Western Europe.  Then early this year Greece faced a debt default and had to be rescued via a huge EU-IMF bail out in May.  The EU and IMF then established a 750 billion euro fund to support future bailouts of European countries. 

Last month, a EU summit agreed that to set up a new system by 2013 in which private investors in government bonds would also have to bear part of the cost of bail outs.

There are no details yet of this system, though it is known the Germans are contemplating a European debt workout system, in which the creditors or bond holders would take a “haircut” (or partial loss), if a country is unable to repay its debt in full.

The fear of this system triggered the sharp rise in the yield of Irish bonds, to 9% at one stage, before the finance ministers' statement (clarifying that the new system would not affect holders of existing bonds) calmed the markets somewhat.

This latest market turmoil showed the vulnerable situation of the three or four European countries, and moreover how fragile too is the future of the euro single-currency itself.

The European crisis reminds one of the Asian crisis more than a decade ago, when one country after another was affected by the contagion effect until it became region-wide.

This crisis overshadowed the G20 Summit, which has disappointed most analysts for not having any concrete results.  The considerable differences that major countries had before the Summit remained at and after the Summit, and thus the underlying problems are unresolved and will make a global economic recovery difficult.

At the Summit the leaders agreed to disagree, and their different concerns (including about one another) were reflected in the obscure language of the G20 Communique.

Most of the key issues are in the paragraph on Monetary and Exchange Rate Policies.  It says, “We will move toward more market-determined exchange rate systems and enhance exchange rate flexibility to reflect underlying economic fundamentals and refrain from competitive devaluation of currencies.”

This reflects the major US concern that China's exchange rate is undervalued and should be allowed to appreciate significantly.  China however succeeded in avoiding any explicit mention of its currency situation.  Each country will be able to interpret this sentence in its own way.

The statement also says that “Advanced economies, including those with reserve currencies, will be vigilant against excess volatility and disorderly movements in exchange rates. Together these actions will help mitigate the risk of excessive volatility in capital flows facing some emerging market economies.”

This reflects the strong concerns that developing countries like China, Brazil and South Africa as well as Germany have voiced about the “quantitative easing” (printing of money) policy of the US.

While the US creation and injection of $600 billion into its banks is aimed at economic recovery, its critics say it will weaken the dollar (and is thus a method of competitive devaluation).  It will also cause more “hot money” to move to developing countries in search of higher returns, with adverse effects such as adding to pressures towards inflation, asset bubbles and currency appreciation.

The G20 Communique adds:  “Nonetheless, in circumstances where countries are facing undue burden of adjustment, policy responses in emerging market economies with adequate reserves and increasingly overvalued flexible exchange rates may also include carefully designed macro-prudential measures.”

This reflects the view of the developing countries like Brazil. Thailand and South Korea, that they have the right to make use of capital control measures to stem the inflow of short-term foreign capital.

To avoid the destabilising effects, the developing countries are already using or are planning measures such as placing a tax on various types of foreign short-term capital.

In the past, such measures were frowned upon by the IMF and the developed countries.  Now even the IMF and World Bank have recognised that they are legitimate and useful.

In another paragraph, the leaders pledge to pursue policies to reduce excessive imbalances and to maintain current account imbalances at sustainable levels.  They agreed to have “indicative guidelines” and “a range of indicators” to identify large imbalances that require actions to be taken.  These guidelines will be prepared by next year.

This reflects a much diluted version of the US proposal that countries should limit their current account surplus or deficit to 4% of their GDP, and thus reduce the present global imbalances.

However, many countries including Germany and China have rejected having quantitative limits.  The US thus failed in having its 4% number but it succeeded in getting its idea on the agenda. The follow up work is on indicative guidelines.  Other countries injected in the text that there be a “range” of indicators; thus indicators other than deficits and surpluses will also be included.

The G20 Communique thus contains the different concerns of the countries while giving them sufficient space to continue with their policies.   This has opened the G20 to the criticism that they merely papered over their differences without being able to agree on the problems and the solutions.

At least the leaders met and opened channels of dialogue.  That's not good enough, but better than not talking at all.