The Fate of the G8 and China

The market has long regarded the periodic G8 meetings as largely photo opportunities. It has been nearly two decades since monetary policy was coordinated. Although it appeared to provide a useful forum for coordination of attempts to curb the financing of terrorism, it may have outlived its usefulness as currently conceived. Like the weighted voting at the IMF, the G8 no longer reflects the the distribution of economic power.

Recently the G7/8 meetings have been more disruptive than constructive. Recall the April 06 meeting, when the industrialized countries and the IMF seemed to call for greater dollar depreciation. That arguably helped trigger the May/June swoon in emerging markets and a sharp counter-trend drop in the dollar against the yen, which took the market the next several months to recover. Or more recently, this past February, when the euro was trading near JPY158-JPY160, a number of European finance officials ahead of the G7 meeting, raised concern about the yen’s weakness than the appropriateness of yen-carry trades. This sparked around a 6% slide in the euro against the yen in about six days. It took the euro about six weeks to recover and now on the eve of the G8 meeting, it was trading near JPY164, with hardly a peep of concern.

It is one thing for the market to dis the G7/8 meetings. It is another thing when policy makers begin showing it a lack of respect. Although it was not announced as such, the fact that German Finance minister Peer Steinbrueck did not attend the April meeting, is likely best understood as a political signal. Germany was apparently protesting what it, as the head of the G7 saw as an the apparent US effort to deliver the G8 a fait accompli regarding hedge funds by publishing its findings to preempt support for Germany’s initiative.

This G8 meeting is the first since Steinbruek opted for a family vacation rather than attending the G8 meeting in Washington, DC, and lo and behold US Treasury Secretary Paulson won’t attend. Although Deputy Treasury Under-Secretary for International Affiars Clay Lowery denied linkage, to paraphrase The Bard, methinks the gentlemen protests too much.

The reason cited for Paulson’s absence is his priority on next week’s strategy talks with China. Even if that were a convincing excuse, it would still belittle the G8 meeting insofar as it tacitly recognizes a more important economic relationship than the G8. Not to put too fine a point on it, but China should be a member of the G8. Its economy is more than twice the size of the Russian economy (which makes it the G8 rather than the G7). China, unlike Russia, is a member of the WTO.

Not only will Paulson not attend, but the UK Chancellor of the Exchequer, Gordon Brown, who will be the next Prime Minister is cutting his attendance short and France’s new economic minister was just named today, former Labor Minister Jean-Louis Borloo, who understandably cannot be assumed to be on top of the issues.

These issues seem rather minor and of G8 meetings this one in particular is not critical. The central bankers are not in attendance and the purpoose is largely to set the terms of the June 6-8 economic summit of the heads of state. Yet at the same time, these events taken individually and collectively are both cause and effect of the demise of the G8 as a signficant forum.

Moreover, in the face of nearly universal pressure to accelerate the pace of currency appreciation, China has stolen the show. As the G8 meeting was about to begin, and a few days ahead of high level talks with US officials, and shortly before the next Treasury Dept report on the currency markets, China announced a small widening of the dollar-yuan band to 0.5% from 0.3%.

If the G8 comminique was already drafted, its going to have to be changed to recognize China’s move. It was a savvy political move even if the economic impact is minor. While not a member of the G8, China demonstrated that it can strongly influence if not dictate its agenda.

The G8 has to recognize today’s steps and others that China has announced in recent weeks to liberalize its capital markets as positive developments and will encourage China to do more. Nevertheless, China’s move on the yuan is largely insignificant. The previous 0.3% daily band had never been fully explored. So the direct cost of the widening of the band to China is minor. It is little more than throwing a bone to its critics. The size of the new dollar-yuan band is half the size of the band that was permissible under Bretton Woods, which was a fixed exchange rate regime. It is about a fifth of the size of the fluctuation of the old European Exchange Rate Mechanism (2.25%).

The China’s move is unlikely to satisfy its numerous critics, especially in the US. Some in the US Congress argue that the yuan is 40-50% under-valued. It will be argued that the widening is symbolic, not substantive. The widening of the band is unlikely to alter a single vote on the numerous punitive bills making their way through the US Congress. It is unlikely to seriously impact the Strategic Economic Dialogue Sino-US talks next week.

It may, on the margin strengthen the hand of those in the US Treasury that do not want to cite China as a currency market manipulator in the semi-annual report due in the coming weeks. However, there appears to be mounting pressure to cite China. It would seem to be consistent with the rapprochement between the Bush Administration and Congress on trade. The Bush Administration capitulated to Congressional demands to include worker and environmental protection in exchange for assurances of congressional approval for some of the previously negotiated bilateral agreements. The Bush Administration hopes that this could serve as the basis to get the President’s Trade Promotion Authority (fast-track) renewed, even if limited to the Doha Round at the WTO, which could help breathe fresh life into the moribund negotiations.

Citing China as a currency market manipulator would be a largely toothless policy, but it would be a low cost bone to throw to the Administration’s critics in Congress. The penalty for being cited is negotiations with the US, which China is already engaged in. China would lose some face, but not seriously, as Chinese officials used to tell stock investors, there is a difference between weeds and flowers. Being cited would be a weed.

A positive outcome of the downgrading of the G8’s significance is that it may reduce the emphasis on the currency markets. Treasury Secretary Paulson has acknowledged that an appreciation of the yuan is unlikely to produce significant results on the bilateral trade relationship, which he says is a consequence of divergence macro-economics, like savings imbalances. Although the cheap yuan may help enhance China’s competition, the chief source of its competitiveness is low wages, which the Asian Development Bank estimates are roughly 1/33 of US manufacturing wages. Note too, that the euro and Canadian dollar have appreciated by more than 50% against the US dollar and the bilateral imbalances have grown.

Nor should we expect the minor widening of the dollar-yuan band to have much impact on Asian currencies. Many observers have suggested that the Chinese stubbornness regarding its currency limits the scope for the regional currencies to appreciate. But this overstates the case. Consider that over the last 12-months, while the yuan has appreciated 4.5% against the dollar, the Thai baht has appreciated 15.5%, the Philippines peso has appreciated about 13%, the Indian rupee 11.6% and the Malaysian ringgit has appreciated by 6%.

The G8 meeting and China’s moves are examples of politics as theater and will likely have little sustained impact.