Tomorrow, finance ministers and central bankers from seven wealthy countries in the developed world will convene in Marseilles, France for their regular meeting to assess the health of the global economy. After a few global gatherings when the economic outlook appeared more promising in 2009 and 2010, the G7 agenda is back to battling contagion — negative spillovers from one financial institution, market or country to another. Recent volatility stemming from European bank funding concerns, protracted fiscal consolidation debates and sharp movements in exchange rates threaten to upend the global recovery. The G7’s ability to cooperate on these three issues will determine the course of contagion — either recurrence or remission. Therefore, during a week when the U.S. President is rightly focused on job creation, managing contagion will be as much a priority for the G7 as promoting growth.
The issue of European bank funding and capitalization should be watched closely because of the threat it poses to global financial stability and global policy coordination. With the European Commission standing by the adequacy of bank stress test programs while the Federal Reserve, IMF Managing Director, Deutsche Bank CEO and U.S. money market mutual funds call attention to the ability of European banks to cope with sovereign debt strains, the issue could become the biggest source of policy divergence among major economies. Further close cooperation across national boundaries and between policymakers and market participants is necessary to allay concerns about systemically important European banks.
Already, questions about the damage sovereign debt holdings could inflict on bank balance sheets have driven U.S. money market mutual funds, which hold nearly half of their assets in short-term European bank paper, to curtail their exposure. Some funds reported avoiding lending to banks in France, Spain and Italy entirely. Others stopped rolling over maturing short-term loans. As crucial sources of short-term funding pared back, the cost of borrowing for European banks rose. The spread between forward rate agreements and the overnight indexed swap rate in Europe, a proxy for the future premium banks will charge each other for loans, widened to the highest level since early 2009. Both European and American banks reported a steady climb in the cost of 3-month dollar loans in August. And, the cost of insuring against the default of financials spiked to a record high in recent weeks, as evident in 5-year credit default swap indices. Spreads have improved at times, on the back of encouraging news such as the German Constitutional Court’s decision to uphold that country’s participation in European sovereign rescues. Still, insufficient, opaque and divergent policy responses to concerns about European bank balance sheets could drive borrowing costs higher, putting more pressure on bank funding. The pressure may not be as severe as it was in September 2008, but enough to constrain credit and risk-taking during a period when both are needed to support the recovery.
Protracted, unpredictable budget battles in the United States and Europe have also thrown markets into chaos. As fiscal consolidation and financial stabilization plans hung in the balance in legislatures on both sides of the Atlantic and disillusioned constituents gridlocked capitals throughout Europe, investors fled riskier asset classes such as financial stocks and European sovereign bonds. Global equity markets lost approximately 20 percent of their value from July to August, led by financials. The spread between Greek and German 2-year bond yields soared to 246 bps and the cost of insuring against the default of Western European sovereign bonds exploded to a record high in recent weeks. In most G7 countries, the power to approve, challenge and design fiscal rebalancing and financial stabilization packages lies with national legislatures. Therefore, the most daunting task on the G7 fiscal agenda is not to seek consensus among finance ministers, but to secure support from key national legislatures that will ultimately determine the course of fiscal rebalancing.
The G7’s ability to calm market fears about the direction of fiscal policy will depend on the effectiveness of finance officials to work in partnership with divided legislatures and the vocal constituencies they represent. G7 finance officials will have an opportunity to do so this fall, when key legislative battles will be taking place. Currently, the Italian Parliament is debating an austerity bill, with a Senate-approved package moving to the Lower House for a vote next week. This week’s German Constitutional Court ruling upholding the country’s participation in European rescue efforts nonetheless affirmed an influential role for the Bundestag in approving future sovereign bailouts. In the United States, the bipartisan congressional ‘super committee’ formally meets for the first time this month with a mandate to decide on a budget plan by the end of November. In all but one G7 country, the finance minister is an elected official. One hopes these ministers will employ their relationships and skills to win over powerful domestic constituencies.
Contagion fears have also fueled a sharp appreciation in safe haven currencies, threatening to hurt the competitiveness of Japanese and Swiss exports during a fragile recovery period. In a year filled with turmoil, from the revolutions in the Middle East to the Japanese earthquake-tsunami and budget battles in the West, investors have repeatedly flocked to safe havens, driving up the value of favored currencies to levels that have been deemed as threatening by government authorities. Earlier this week, the Swiss National Bank imposed a minimum floor on the euro-franc exchange rate. In an economy where 40% of GDP comes from exports and 61% of all exports go to the European Union, this move was only the latest in a series of efforts by Swiss authorities in 2010 and 2011 to halt excessive appreciation. Japan has also intervened several times in the last 12 months, including a concerted G7 sell-off of the yen following the earthquake in March.
The G7 is likely to maintain its previously articulated view that exchange rates should be market-driven while also demonstrating vigilance against excessive volatility. But, this year, unlike recent years, attention on currency intervention has shifted away from China’s under-valued currency to over-valued safe haven currencies such as the Japanese yen and Swiss franc. Even tacit approval for successive foreign exchange interventions by advanced countries indicates that the G7 has turned the corner from pressuring China on yuan under-valuation to protecting safe haven currencies against over-valuation. Though continued yuan appreciation is key to rebalancing the global economy and G7 countries will be supportive of this, chiding China will no longer be the focal point of global economic gatherings. The deceleration of legislative and oversight activity in the U.S. Congress accommodates this shift in the currency debate. The U.S. Congress no longer bothers to ask Treasury for its findings on Chinese currency manipulation much less demand votes on punitive legislation. The question now is, will the rest of the world agree to stay on the sidelines of exchange rate interventions, or will more countries step through the gateway to competitive devaluation? With economic anxieties running high around the world, the G7 is well suited to lead countries to an appropriate answer to this question. After all, the pursuit of currency stability was one of the main issues that prompted French President Valery Giscard d’Estaing to initiate the first high-level meeting of the United States, France, United Kingdom and Germany in 1975. This gathering formed the basis for the G7.
The international community successfully rallied together to battle the subprime meltdown in 2008. It’s time they do so again. No global financial center was immune to the recent decline in confidence, credit and job prospects. The risks to stability remain high, with divergent policy on capital, divisive domestic fiscal debates and an open door to competitive foreign exchange depreciation. To overcome contagion fears around capital, consolidation and currency, the G7 must push for further cooperation across countries, between domestic authorities and with market participants.
Julie Chon is a nonresident senior fellow with the Global Business and Economics Program at the Atlantic Council. She was senior policy advisor on the U.S. Senate Committee on Banking, Housing and Urban Affairs from 2007-2011. This piece originally appeared on The Wall Street Journal.