Stephen King: G7 club must invite new members or die

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The Independent Online

On Friday night, the G7 finance ministers and central bank governors issued a statement strongly urging the Chinese to allow an "accelerated appreciation" in the renminbi's value sooner rather than later. This was, apparently, in China's own interests – because a revaluation would help to put a lid on rapidly rising domestic inflation – but would also make a major contribution to the resolution of global imbalances.

Meanwhile, Jean-Claude Trichet, president of the European Central Bank, called for the US to reaffirm its strong dollar policy (even though this would presumably contradict a strong renminbi policy). Hank Paulson, US Treasury Secretary, didn't exactly contradict M. Trichet, but did argue that currency levels should be determined by market forces, thereby offering his seal of approval on the dollar's decline to date against the euro, sterling and other currencies in the industrialised world.

To all of which I say: so what? The G7 is an anachronism, a throwback to the 1980s when its members really could deliver economic policies for the greater good. Back then, the G7 represented the world's major industrialised countries. The finance ministers' meetings were a useful way of providing economic conflict resolution. If the dollar was too strong – as it had been in the first half of the 1980s – the G7 could deliver a Plaza Pact designed to lower the dollar's value. If the dollar was too weak – as it had become by 1987 – the G7 could deliver a Louvre accord, designed to stabilise the value of the world's reserve currency.

In those days, most of the conflicts occurred within the G7. If America's balance of payments deficit was too big, this was likely to reflect excessive balance of payments surpluses in Japan and Germany. If global interest rates were too high, the US budget deficit was the likely culprit. If US domestic assets were being snapped up by foreigners – the sale of the Rockefeller Centre springs to mind – those foreigners were likely to be Japanese. The G7 was a useful club because all the economic powerhouses were members.

Today's powerhouses are a very different bunch. Yes, the US is still important. Japan is still a rich economy, but it has been stagnant for 15 years. Germany, France and Italy may be well off, but their economic interests are bundled together in a eurozone represented by a powerful central bank but no single finance ministry. The UK and Canada try to play their roles as "honest brokers", but are fooling themselves if they really believe they have positions of significant economic influence in the modern world.

Above all, there's the emergence of the new economic superpowers. China, India, Russia (a member of the G8 but not involved in Friday's statement) and the Middle East are major players, for a variety of different reasons. Each of them now has an influence on economic conditions within the G7, for better or worse.

Why are oil prices so high? Look no further than China, where economic growth is incredibly rapid, driven by the remarkable pace of industrialisation and urbanisation. Why has the US been able to run a persistently large balance of payments current account deficit? Because China, Russia, Saudi Arabia and the Gulf states are happy to buy US assets. Why has food price inflation lifted off? The most compelling explanation is not so much supply shortages or the sudden increase in demand for bio-fuels (which reduces the supply of agricultural land for food purposes), but the huge rise in demand for rich man's food from urban consumers in emerging markets who prefer to eat meat rather than grain, a reflection of rising affluence.

The emerging markets are changing the ways in which we should think about the world. In the late 1990s, the US was seen to be the "consumer of last resort". No longer is this true. The pace of US consumer spending growth has tempered in recent years, but the world economy has enjoyed a period of rude health, with the loss of momentum in the US economy offset primarily by burgeoning demand in emerging markets. Their share of global consumption and, in particular, global capital spending has sizeably increased through this decade.

This, in turn, means that many of the challenges facing the world's policymakers stem not from the G7 but from the emerging markets. They indirectly contributed to the sub-prime crisis. Their central banks invested heavily in US government paper and so government bond yields fell. In response, private investors were tempted to put their money in more exotic areas. Securitisation took off and the structured products boom began, channelling too much money into the US housing market.

Emerging economies will also have an impact on the likelihood of finding solutions to the sub-prime crisis. Faced with a tightening of credit standards as financial institutions cut back on their willingness to lend, the obvious thing for central banks to do is to cut interest rates. That, after all, is what the Federal Reserve achieved in the aftermath of the LongTerm Capital Managementcrisis in the autumn of 1998.

Then, though, the emerging markets were in a state of collapse. As a result, commodity prices were in freefall and the dollar was strengthening. Both factors contributed to lower US inflation – through lower import prices – making it easier for the Federal Reserve credibly to cut interest rates.

Today, emerging markets are exerting upward pressure on global inflation. Their economies are mostly overheating and, because they tie their currencies to the US dollar, it's difficult for them to tighten domestic monetary policy if the US is in the business of cutting interest rates. Strong emerging market growth points to higher oil, food and metals prices and, ultimately, makes the deliverance of price stability more difficult in the developed world.

The G7 nations argue that emerging markets, instead, should set interest rates for domestic purposes and allow their currencies to either float or revalue. Imagine, though, what might then happen to the US dollar. Arguably, the dollar's decline so far has been orderly precisely because emerging market central banks have been happy to buy dollars even when other investors have lost their appetite. Should emerging market central banks also give up on the dollar, the US currency might be thrown into a tailspin, with broader financial chaos following soon after.

All of this sounds really rather nasty. It needn't be. One aspect of the global economy's performance is improving. Over the last few quarters, the US balance of payments current account deficit has started to shrink. That's without a major revaluation of emerging market currencies. This is a rather remarkable development. Once again, it's likely to reflect an emerging markets influence.

Growth in emerging markets is so rapid that it's beginning to have a major influence on US trade. US politicians may be quick to blame the Chinese for heightened job insecurity or the Middle East for higher oil prices but perhaps US exporters are beginning to benefit from America's growing exposure to the emerging world.

The G7's economic destiny is tied more and more to emerging market developments. That, in turn, suggests that the G7 finance ministers should invite new members to the club, because, without them, the club will wither and die.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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