Great Another G8

Hosted by Russia, the leading industrialized nations will meet this weekend. There is no reason to expect new initiatives that would impact the global capital markets and especially the foreign exchange market. Energy and Iran appear more salient for policy makers than the markets per se.

There was trial balloon floated by the US for the IMF to take on a greater role in monitoring the foreign exchange market, but there are all kinds of practical difficulties, even if it finds conceptual agreement. Given that a number of loan recipients have made back their debt early and no new programs have been initiated, we need to be careful of mission creep. On practical grounds, it seems difficult to have operational definitions and appropriate time-frames. For example, China has taken numerous steps over the past 6-8 months that appear to be in the desired direction, including a basket approach and a band, a market-making system and new rules on interest-rate swaps. Many officials, especially in the US and Japan, want China to accelerate its moves, but the message is mixed.

Some call for outright currency appreciation, based nearly exclusively on China’s trade surplus. These officials seem to be cynical about the market’s ability to set an appropriate value for currencies, despite lip-service paid to market mechanisms. A former Japanese MOF official had previously written on op-ed piece in the Financial Times calling for China to re-value the yuan by 5% a year for the next 10-years.

Other officials call on China to make its currency regime more flexible and more determined by market forces. They seem to believe that the market would take the yuan higher. However, this is not necessarily the case. Consider that a great deal of hot money has poured into China “betting” on a substantial revaluation. If China were to open up its capital markets and allow the market to set the yuan’s value, it is possible that a “buy the rumor, sell the fact” type of activity transpires and leads to outflows from China as the hot money look for the next play. Multinational companies that currently encounter some difficulty in repatriating profits from China would be freer to do so and would also likely become more visible sellers of yuan. In addition, like the economic elites of other development countries do, the millionaires being created in China would also likely put some of their wealth off-shore, if they could.

Ideas that an appreciation of the yuan will solve resolve the large US trade deficit are misplaced on two scores. First, the appreciation the yen has not ended Japan’s trade surplus with the US. Indeed, the US bilateral trade deficit with Japan in 2005 of more than $82 bln is second only to China. Currency appreciation/depreciation seems to be a false elixir to cure the global imbalances. Second, it misunderstands how China competes in the world economy. The essence of China’s competitive thrust rests largely on three legs. Manufacturing wages are roughly 1/33 of prevailing US wages. Chinese productivity has been rising at 15-17% for a few years. And they have encouraged global companies to locate production facilities and assembly work in China.

Energy

In his State of the Union address, US President Bush announced that he wanted to free the country from dependence on foreign sources of energy. Given that the imports meet roughly half of the US energy needs, such a goal seems out of reach in any meaningful time frame. Moreover, even if such a goal was practical, it is not clear that it is desirable. Such a strategy is tantamount to a retreat from the interdependent global economy the US has been instrumental in building.

What might be more desirable and practical would be a more serious conservation program and a diversification of the sources of our energy inputs. The good news is the latter appears to be taking place. Over the last several years, the US has been importing an increasing amount of oil from Africa. For example, between 2000 and 2004, US oil imports from Africa increased by more than a third, while oil imports from OPEC were largely flat. Indeed, in the first ten months of 2005, the US imported more oil from Africa producers (762 mln barrels) than from the Middle East (703 mln barrels).

Separately, but not unrelated, note that the G8 finance ministers are asking Brazil for advice on expanding production of alternative fuels like ethanol and bio-diesel. Brazil makes its ethanol from sugar, which is more efficient than producing iit primarily out of corn, which is what the US does.

Iran

Iran’s pursuit of nuclear technology is unlikely to be resolved at the G8 meeting. The important point, however, is the commitment by all of the Security Council members, including the United States, to deal with the problem through political and diplomatic channels and not the exercise of military options.

Reports indicate that Iran has distributed its nuclear activities in numerous locations throughout the country. Having learned from recent history, they hare not as vulnerable to a single air strike, say the way Iraq was, even though this seems to be one of the scenarios that market participants bandy about.

The confrontation with Iran is still in the early stages and while sanctions later this year seem increasingly likely, they probably will not include oil. Iran exports about 2.5 mln barrels of oil a day. The world needs that supply. And the Iranians need to sell it. The new government has promised a 17% increase in domestic expenditures in FY06 (March 2006-Feb 2007). Oil accounts for almost half of the government’s revenues. An international boycott of some of their other goods does not appear to be as destabilizing for Iran as it has extensive experience in circumventing such treatment.

Some Washington-based contacts suggest that many senior US officials recognize that it is almost impossible to prevent Iran from acquiring nuclear capability. Instead, these contacts suggest, the real goal is to delay the acquisition as long as possible, hoping that a more moderate regime arises.

The bottom line is that the G8 meeting, like most of its predecessors, is unlikely to have any impact on the foreign exchange market. Despite speculation to the contrary, China is not about to announce new significant changes to its currency regime. And even if it would, it is unlikely to be the panacea that some have suggested for the US trade deficit. The market is not waiting for the Chinese to move before bidding up other regional currencies. The domino-theory did not work in politics, nor does it appear to be useful in the foreign exchange market. The challenge posed by high energy prices and Iran’s pursuit of nuclear technology will not be resolved at the weekend G8 meeting.