What is likely to happen at the November 15th G20 meeting and why? Although it was not Nicolas Sarkozy but a group of 11 Commonwealth countries who floated the idea in June 2008, the French President called in October for a global summit to “rebuild regulated
capitalism”. The speed at which the meeting was decided and is being organised is stunning, the dynamics are impressive. The survival of the world’s financial system, avoiding the disintegration of the global economy, is at stake. What can we expect?
The financial crisis is spreading faster than economists can even explain it. By the time we thought of a remedy to the US real estate meltdown, the European interbank network was contaminated by a crisis of confidence. By the time the US and Europeans voted
a bank rescue, the stock markets cracked. By the time we think of stimulating the economy to support the stock markets, a monetary crisis looms, industrial giants are on the brink of collapse. It is getting serious.
Let’s face it, the Western economies are cornered. With a national debt of US$10 trillion for an estimated GDP of US$14 trillion, the US have already reached a historic 71% debt ratio if 2008 budget is met, which is unlikely. How to deal with a shock recession
then without further deepening an abyssal public deficit of US$455 bn? The Euro zone is not better off, for their ratios are about as bad while their hands and feet are tight under the Maastricht Treaty fixed ratios (60% debt and 3% public deficit). This discards
the use of Keneysian economics, increasing demand through state spending and tax cuts, which President Obama is about to embrace, just like Kennedy did before him. The deficits shall look ugly, but yes, he can. The Eurozone on the other hand is stuck under
the dogmatic foundations of the Euro, which increasingly looks like a fixed exchange rate system among disparate countries rather the unique currency of a single economy.
Against this backdrop, the G7 Treasuries are requested to save the banking system, bail out the insurance industry, recycle non-performing loans, support the automobile industry, just to name a few. The IMF is at the rescue of Iceland, Hungary, Ukraine,
Pakistan, and there is probably more coming. But what are the US$200bn of the IMF and even the US$700bn TARP package against trillions in credit default swaps which need deleveraging? Nobody knows exactly where they are, nor the clauses under which the protection
buyers can call their notional. All we learned, on Lehman’s day, is that any of these instruments can strike, any time, any place. They are triggered by raising default probabilities, under a widely used theoretical model which factors in equity prices.
The only way out of this seems to organise an orderly flow by which cash rich economies such as China, Japan and the middle-East fund the Western economies. A usual bond issuance spree, repackaged by a handful of key investment banks then re-purposed to
fund the world’s investments will not happen this time, however. With a banking system in tatters, over- indebtedness and a shock recession to deal with, the West does no longer have the balance sheet to receive another blank check from the Sovereign funds.
Fortunately, cash rich countries happen to be emerging economies which were recently reminded that their own wealth depends on the spending capacity of the Western world and that their cushions can deflate at a staggering pace in a global recession. So they
too are motivated to work at making it work.
So the G20 meets in emergency, without an official agenda but with converging interests and enough fears for everyone to think collectively. Should they forget this, the stock markets might give a bitter reminder next Monday. The EU is likely to drive the
agenda: Surveillance and rules of governance, convergence of accounting and valuation standards, dealing with tax havens, code of conduct and corporate ethics with regard to risk management, the role of the IMF.
No one will argue with this wishful thinking, but what is likely to truly come out of the meeting? We already know that it will end on joyful celebrations and hugs, then there will be a 100 days of work on projects that are probably already decided.
The biggest changes may be related to the rethinking of the role of the IMF. Once a key lender in Special Drawing Rights (SDRs) as a reserve asset, the IMF has seen his role and influence shrinking since the floating rate regime generalised in the 70s. It
still holds an estimated US$100bn in gold, and a basket of 4 major currencies. On one hand, the IMF needs refunding to cope with the growing demand on indebted emerging economies suffering from the credit crunch. On the other hand, it has been suggested that
SDRs of a new type, involving notably the Chinese Renmibi, would better reflect the importance of the weights of emerging economies. So getting the IMF refinanced by the cash rich economies in exchange for international credit guarantees and less dependence
on the US Dollar would be satisfactory to most. The large holders of US dollars as reserve would finally get an alternative without dumping the currency against their own interests. New economic powers would take centre stage, and the Europeans would finally
achieve the political dream of counterbalancing the weight of the US dollar in international exchanges. The US will be relieved of a burden carried sometimes painfully since WWII. Once the currency is freed from its reserve status, the Obama administration
will be allowed to let it fall at will without destabilising the Treasury and the World economy. A key discussion would be the composition of the basket and whether gold still needs to play a role in it. The influence of emerging economies could be moderate
or even symbolic in the first place, with a scheduled review further down the road. In such case, the Euro would de facto play a major role as of reserve currency, which will make monetary policy of the Euro zone even more rigid and distant from local realities,
a move which over time may even lead to the disintegration of the European currency. By contrast, the US and UK economies should naturally recover, after a plunge into abyssal public deficits though.
The banking regulatory framework should be entirely reviewed. The Basle Committee was arguably some form of self-regulation of the banking sector. It is no longer acceptable to governments who commit taxpayers’ money and do not understand why their rates
cuts fail to produce the expected outcome. A new framework will emerge, which may look as the polar opposite of the previous one: Predictive modeling will likely be discouraged, ratings agencies will be under strict scrutiny. The new framework will focus on
accountability, transparency, will require firms to continuously monitor and report their risk exposures. It may also ban the bridges over activities such as retail and investment banking, securities and loans, trade executions and broker dealers. The aim
would be to avoid the spread of contagion -the spirit of a new Glass Steagall Act.
The remaining question is who to appoint as the new watchdog of the banking sector? The fall guys are the World Bank and again the IMF, which were precisely in search of new purposes. Concentrating all regulatory and supervision roles in a single supra-national
administrative entity may actually create more systemic risks than it will address but the principle fits very well the current mood and is a typical European model.
The rhetoric on tax havens and executive compensations is necessary to make sure there will be at least one point that everyone can wholeheartedly agree upon, and that the public understands at least one item on the agenda. It does not cost much as it is
probably not implementable, but it helps the Europeans increasing their pressure on Luxemburg and Switzerland to tear apart what’s left of their banking secret and it may discourages some customers of the likes of Lichtenstein, Andorra or the Caribeans by
way of intimidation.