Chris Giles - Overview: Dark outlook piles pressure on leaders

Financial Times, November 2, 2011 2:24 pm

http://www.ft.com/intl/cms/s/0/a85142c4-ffef-11e0-ba79-00144feabdc0.html#axzz1cfDufkdf

By Chris Giles

It is crunch time for the Group of 20. If things go well, the Cannes summit will mark the moment the “premier global economic forum” acts to defuse the economic risks being run in the world. The alternative is to allow them to fester, contributing towards another destructive financial and economic crisis.

Underlining the urgency, the International Monetary Fund declared in mid October: “The immediate risk is that the global economy tips into a downward spiral of increased uncertainty and risk aversion, dysfunctional financial markets, unsustainable debt dynamics, falling demand, and rising unemployment”.

Three challenges stalk the global economy.

Most pressing is the declining prospects for growth, which have become evident in the weeks following the IMF annual meetings in late September. Then, the IMF had already downgraded its economic forecasts and warned of further risks, but most emerging economies were still growing rapidly and had experienced little fallout from the slowdown in almost all advanced economies.

Six weeks on the world outlook seems darker notwithstanding the eurozone agreement a week before the G20 summit. As the Organisation for Economic Cooperation and Development outlined on Monday, “Uncertainties regarding the short-term economic outlook have risen dramatically in recent months.”

The OECD significantly downgraded its 2012 growth forecast for the world economy and for advanced economies, cutting the forecast from 2 to only 0.3 per cent and its US forecast from 3.1 to 2 per cent.

A rapidly cooling global economy is both the consequence and cause of the eurozone sovereign debt crisis. As the second challenge – one which has frayed investors’ nerves and knocked business and consumer confidence since the summer – fixing the existential crisis of the European single currency is a pre-requisite for a safer global economy next year.

The crisis has many dimensions, ranging from the insolvent Greek economy, through a dip in confidence in the peripheral sovereign debt of Italy and Spain increasing their borrowing costs substantially, and to a weakness in the balance sheets of European banks sitting on these assets. The issues are inextricably linked and must be addressed as a whole, as recognised by both the French and German government’s commitment to a “comprehensive plan”, the outlines of which were revealed last Thursday morning.

If the eurozone crisis was not difficult enough, deep trade imbalances are the third challenge facing the G20. According to the IMF, current policies on trade and exchange rates suggest that enormous current account surpluses in China, Japan, Germany and relatively poor oil exporters are set to continue, forcing ever more capital to flow to finance deficits elsewhere which must balance the surpluses.

Since well before the crisis, individuals and governments in surplus countries enjoyed building claims on deficit countries, but much of this capital ended up financing increasingly risky activity at cheap rates – sub-prime mortgages and peripheral eurozone sovereign debt – adding to the risks that these investment flows would end in crisis and huge losses.

As Mervyn King, governor of the Bank of England, said recently: “From the very beginning of the global crisis there has been a reluctance by governments to face up to the underlying solvency problems generated by apparently unending trade deficits with no mechanism, whether flexible exchange rates or some other means, for correcting these disequilibria”.

In short, the task for the G20 summit is to accelerate solutions to the latter two challenges so as to mitigate the slowing global economy and set it on a path towards the G20’s long-standing ambition of “strong, stable and balanced” global growth.

France, the chair of the G20 in 2011, is well aware of what needs to be done. Speaking to the United Nations a week before the summit, Jean-David Levitte, the diplomatic advisor on the G20 to French president Nicolas Sarkozy, recognised the original agenda of the summit must be torn up and replaced with a coordinated response, because “no one is immune from the economic crisis”.

“France is calling on all G20 countries to adopt measures adapted to the situation and on all countries that don’t belong to the G20 to support the collective efforts that will be undertaken to restore confidence,” he said.

For the G20 to play a part in any solution to the eurozone woes, non-members of the single currency area made it clear at a finance ministers’ meeting in Paris in mid-October that the euro nations first had to demonstrate they had a “decisive” plan to save the single currency.

That plan – the outlines of which were agreed at a eurozone summit a week before the G20 summit – included a comprehensive recapitalisation of European banks, a 50 per cent voluntary write-down of Greek debt leaving the beleaguered country with more sustainable debts, a beefed-up fund to prevent contagion spreading from Greece to other eurozone economies and medium-term reforms to the governance of the eurozone to prevent a recurrence of fiscal and trade imbalances within the zone.

The enhanced European Financial Stability Facility will have two elements in a package with more than €1,000bn of firepower: limited insurance for sovereign debt of peripheral countries and a new leveraged fund to buy debt outright.

Underpinning the details is the idea that medium-term German and French finance for peripheral eurozone countries will be balanced by German and French control of economic policy across the eurozone, in what Angela Merkel, German Chancellor, euphemistically calls a “stability union”.

Once these elements of a package are agreed, the French hosts hope that non-eurozone countries will boost the credibility of the plan at the G20, either through additional bilateral or IMF support. The aim would be to provide overwhelming firepower behind the eurozone and stop traders betting on a eurozone break-up.

G20 finance ministers made clear in Paris that such a deal was a possibility, though it is far from a certainty in Cannes.

Speaking in a similar vein to many non-eurozone finance ministers, Tim Geithner, US treasury secretary, said: ”The IMF has a substantial arsenal of financial resources, and we would support further use of those resources to supplement a comprehensive, well-designed European strategy alongside a more substantial commitment of European resources.”

In contrast to hastily devised plans to defuse the eurozone crisis, the G20’s progress in reducing global imbalances inches forward at glacial speed. The added difficulty, as Mr Levitte makes clear, is that unlike in 2009, there is no unifying theme for action needed to foster a stronger and more balanced global economy.

He says: “The message from Cannes will have to be more diverse; some nations need to focus on measures to boost their economy, others on consolidating their public finances, and still others on rebalancing their economic models to promote domestic consumption.”

On past experience, gaining agreement on general themes and objectives will be easier than specific changes in domestic policies of any G20 member.

In addition, France is still keen to be seen to have made some progress on Mr Sarkozy’s original ambitions for the 2011 G20 agenda on reforming the international monetary system.

It is expecting specific agreements on rules governing the management of international capital flows – allowing countries in limited circumstances to impose capital controls.

France also hopes to increase the range of IMF credit lines available to help well managed countries that are exposed in a crisis, co-ordinating these flows with those of Europe and Asia.

And it hopes to continue discussion on exchange rates, particularly that of the renminbi, although it acknowledges there will be no breakthrough in Cannes.

But the problem for world economic governance is that it still faces a deep collective action problem.

Policy changes that would foster the common good are seen as counter to individual countries’ domestic interests. This obstacle has forced France to scale back its longer-term ambitions for Cannes.

The potential for the summit to make progress in fighting the immediate eurozone crisis is therefore something of a boon for Mr Sarkozy as he prepares for Cannes. Without the crisis, the potential achievements of the summit were looking extremely limited.