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Unprepared for the worst

Aug 05 2011 10:16 Reuters

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London/Frankfurt - With financial markets in turmoil and economic growth slowing, olicymakers around the world may once again be forced to cooperate to try to head off a crisis, as they did successfully in 2008-2009. But this time, they have fewer good options.

Central banks have less room to ease monetary policy than they did three years ago; cash-strapped governments cannot afford to boost spending as much and political disarray in some countries may make concerted global policymaking harder.

"What can you do? On monetary policy, clearly no one agrees with anyone. On fiscal policy, everyone is blocked," said Deutsche Bank economist Gilles Moec.

By some measures, the global situation is not nearly as bad as it was in 2008. Banks have strengthened themselves since the collapse of Lehman Brothers and the world is still far from a recession.

JPMorgan may have cut its forecast for 2012 US growth this week but it still expects an expansion of 1%.

Global stocks have dropped nearly 10% in the last month, but MSCI's world equity index is still 90% above its 2009 low.

"I know people are saying that this feels very much like 2008 but I don't think we are there. In 2008, you could point at the problem in the banking sector and there were failed banks," said Nomura economist Jens Sondergaard.

Still, the trends have clearly turned negative. National purchasing managers' indexes around the world have dropped near or below the "boom or bust" threshold separating economic growth from contraction.

This week's slide of British government bond yields to record lows underlines both investor nervousness and a grim growth outlook.

In some ways, the situation is more worrying than it was in 2008: there is widespread concern about the risk of a downgrade of the US sovereign credit rating, and a bond market attack on Italy, the eurozone's third-biggest economy, has called into question the area's long-term viability.

Valuations of US and European bank shares are back around levels hit at the time of Lehman's collapse.

"The difference (between 2008 and now) is that this is not only a currency and banking crisis - you have now a currency, banking and sovereign crisis," said Sylvain Broyer, analyst at European financial firm Natixis.

The Swiss central bank’s shock decision to cut interest rates on Wednesday to fight the rapid appreciation of the Swiss franc was seen by some analysts as a possible precursor to concerted efforts by central banks in the Group of 20 nations to stabilise markets.

Steen Jakobsen, chief economist at European investment bank Saxo Bank, said the G20 nations were likely for now to leave it up to their central banks, which can act relatively flexibly and quickly, to handle market turmoil.

But if the economic climate keeps worsening, perhaps with another 10% fall by global stocks, G20 governments may be pushed into making a concerted pledge of action to protect markets and growth as they did at a London summit in April 2009, he said.

G20 trouble spots

By displaying solidarity among world leaders and promising $1.1 trillion for global lending institutions and trade financing, the London summit succeeded in reassuring investors enough to support a recovery in markets and economic growth.

Now, however, it may be harder for governments to show such solidarity. President Barack Obama has been weakened politically and his economic policy options narrowed by his battle to push up the US debt ceiling.

Some big countries are further along in their election cycles, complicating decisions. Important elections are due in the United States, Germany and France over the next couple of years, as well as a leadership change in China.

"The manoeuvrability of governments is much less than it was in the last crisis. A lot of people want to be seen not to be caving in to pressure," Jakobsen said.

During the 2008-2009 crisis, the International Monetary Fund (IMF) played a major role in coordinating the global response, but there are now signs of internal division, with powerful emerging economies criticising the policies of Western governments.

Last month, Brazilian and Indian IMF directors warned the fund's management against pouring more large sums of aid into the eurozone debt crisis, while official Chinese media have denounced US politicians as globally irresponsible over the debt ceiling dispute.

These tensions may complicate G20 agreements on action in several areas:

Joint currency intervention

This is the most likely initial form of G20 cooperation because well-tried mechanisms for it already exist; central banks could send a message that they want stability in markets by intervening massively to stop appreciation of the Swiss franc or Japanese yen.

But China and the rest of the world are still far from agreeing on a more fundamental problem in the global currency system - the value of the Chinese yuan.

Coordinated interest rate cuts

In October 2008, six Western central banks cut interest rates in a coordinated move, while China also eased policy.

Global central bankers may signal an easier policy bias when they meet in Jackson Hole in the United States on August 25 to 27. But coordinated rate cuts look unlikely in the foreseeable future because some central banks such as the US Federal Reserve have very little room left to cut, and central banks are also at different stages in their monetary cycles.

The European Central Bank began tightening this year, criticising Fed policy as too loose; China may still be in tightening mode. A weakening economy might eventually push the Fed and the Bank of England into printing more money through "quantitative easing".

But this would almost certainly not be part of any coordinated G20 move; China and other emerging economies sharply criticised U.S. quantitative easing last year as destabilising for markets.

Expansionary fiscal policy

During the 2008-2009 crisis, the G20 did not resolve differences over fiscal policy; Germany resisted US pressure to boost government spending more. But the London summit in 2009 still produced a pledge of "an unprecedented and concerted fiscal expansion" by G20 states, which cheered markets.

Such a pledge is extremely unlikely now, with the eurozone and the United States desperate to reassure investors that they can bring sovereign debt down to manageable levels. Markets are hoping fiscally strong G20 members may spend more to help weak ones.

Germany could change tack and support a major expansion of the eurozone's €440bn bailout fund in order to provide a precautionary credit line to Italy. China might invest more of its $3.2 trillion foreign exchange reserves in eurozone sovereign debt.

Both these measures might be discussed by the G20 and could have a quick, dramatic effect on markets. But they would face some political opposition within the contributing governments, and would not necessarily change the long-term outlook for economies. 
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