G-20 Overcomes China Opposition to Agree on Yardsticks to Gauge Imbalances

Group of 20 finance chiefs overcame Chinese opposition to start crafting an early warning system to detect when economic fault lines are opening that may imperil global growth.

Seeking to smooth lopsided trade and investment flows which helped plunge the world into a credit crisis and recession, the G-20’s finance ministers and central bankers concluded talks in Paris on Feb. 20 by listing the yardsticks they will monitor to see whether imbalances are forming. Among them: budget deficit levels, the external imbalance and private savings rates.

The scorecard, which will be enforced through peer pressure rather than hard targets, hands the U.S. and Europe a new way of alerting China to the economic impact of a yuan that U.S. Treasury Secretary Timothy F. Geithner calls “substantially undervalued.” After initially resisting the list in all-night talks amid concern it would be used as a weapon against their currency policy, the Chinese diluted some of its language and secured the omission of foreign exchange reserves.

“The bottom line is that we see slow but steady progress towards better international policy coordination aiming at reduced global imbalances,” said Thomas Stolper, chief currency strategist at Goldman Sachs Group Inc. in London. “The G-20 statements are visibly becoming the result of compromise about words and specific expressions.”

Yuan Prospects

The roster of indicators may still be more than investors expected and by encouraging a rebalancing of the world economy away from U.S. demand may initially mean a weaker dollar, said Callum Henderson, global head of currency research in Singapore at Standard Chartered Plc. He predicts the yuan to rise to 6.20 per dollar by the end of the year from last week’s 13-year high of 6.5732.

The G-20 met for the first time this year under the chairmanship of France as inflation begins to replace weak growth as the biggest risk for some of its members, which together account for about 85 percent of the global economy. The officials signalled concern over the new threat by noting some emerging markets are displaying “signs of overheating” and agreeing to study the forces behind surging commodity prices, which pushed oil to a 16-month high in January and world food prices to a record.

The G-20’s statement maintained the view first established last year that its members will enhance currency flexibility and strive to avoid “disorderly movements in exchange rates.” Officials spent most of their time crafting a framework to underpin such rhetoric.

Global Recession
The intention is to avoid a repeat of the last expansion when national trade imbalances opened that later helped trigger the deepest global recession in seven decades. U.S. consumers relied on the low interest rates resulting from foreign borrowing to drive an unsustainable global spending spree and record trade deficit, while China and other Asian nations recycled the dollars from their trade surpluses into U.S. bonds, depressing global yields and providing fresh impetus to the cycle.

The concern now is that new distortions may begin building as the global economic recovery gathers steam, yet does so with engines firing at different speeds. The International Monetary Fund predicts China will remain the world’s fastest-growing major economy in 2011, with a 9.6 percent expansion. The Washington-based lender sees 3 percent growth in the U.S. and 1.5 percent in the 17-nation euro area.

Indicator List
The new plan will require governments to better eye a list of economic indicators that feature public debt and fiscal deficits, private savings rate and debt, the external imbalance composed of the trade gap and net investment income flows and transfers “taking due consideration of exchange rate, fiscal, monetary and other policies.” The next step, at the G-20’s meeting in mid-April, will be to turn these indicators into the basis for a voluntary set of guidelines for economic policy.

The list of indicators will provide rich countries with an alternative to telling emerging markets to “stop manipulating currencies” by allowing them to highlight the “consequences of supporting your currency artificially,” said David Tulk, chief rates and currency strategist at Toronto-Dominion Bank’s TD Securities unit.

U.S. and European officials maintain China’s exchange rate management undermines the world economy by fuelling domestic inflation, filling currency reserves and exacerbating western trade gaps by handing Chinese exporters an edge in global markets. China responds that low interest rates in the west are propelling hot money capital into emerging markets such as theirs and that a quick revaluation of the yuan would risk decimating their economy’s growth.

Currency Reserves
Missing from the list of indicators is currency reserves which now stand at $2.8 trillion in China alone, providing an export-led symbol of its recent rise to become the world’s second-largest economy. China, which had wanted to focus on the smaller trade gap definition, also diluted the final language so that it mentioned the current account’s components and not its title.

“It wasn’t easy, there were obviously diverging interests,” said French Finance Minister Christine Lagarde. The goal is “to test economic policies and determine to what extent they are favorable for all countries together and not just the basis of domestic economic policy.”

Negotiating Power
Helping China push back in the talks were Brazil, Russia and India in another sign of how such developing nations increasingly wield negotiating power commensurate with their recently-found economic strength. The tensions within the Paris talks again suggest the G-20 nations may find it easier to fight fires as they did during the recession than in preventing them.

“The organization is losing relevance,” said Geoffrey Yu, a currency strategist at UBS AG in London.

Geithner used his personal press conference to lambast the Chinese for the yuan’s appreciation, which they have limited to about 4 percent over the past year.

“China’s currency remains substantially undervalued, and its real effective exchange rate — the best measure to judge its currency against all of its trading partners — has not moved much in this latest period of exchange-rate reform,” Geithner said. China is “leaning heavily” against appreciation, he also said.

Chinese Move
On the eve of the meeting, China raised bank-reserve requirements for the eighth time in a year and officials indicated in Paris that they will fight domestic inflation by extending a four-month-old cycle of interest-rate increases.

For all the time spent discussing their threat, imbalances are ebbing. The IMF predicts that China’s current-account surplus will narrow to 5.1 percent of gross domestic product in 2011 from as high as 10.6 percent in 2007, while the U.S. shortfall slims to 2.6 percent from 5.1 percent. The risk is the gaps re-open as the recovery strengthens.

There was little discussion of binding China more closely into the world economy by adding the yuan to the IMF’s synthetic currency basket, known as special drawing rights. Created in 1969 and last reweighted in November, the SDR is a composite of the dollar, euro, Japanese yen and British pound, though its role in markets is minimal.

Current SDR rules would require China to first make the yuan fully convertible, a step that would put it on the upward track desired by the U.S. and Europe. The SDR’s future is on the agenda of a lower-level working group.

“Some conditions have to be met before the Chinese currency is ready,” German Finance Minister Wolfgang Schaeuble said. “The Chinese know this. This goal won’t be reached this year.”