Re-entry dilemma for G20 ministers

September 2, 2009

copeland1– Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. –

As the G20 ministers gather for their meeting this week, there should be no doubt about the item at the top of the agenda: the re-entry problem. At what point should the expansionary monetary and fiscal policy of the past year be reversed? And, if the answer is “not yet”, how soon does the re-entry plan need to be announced?

Since nobody is quite sure how much of the current worldwide economic recovery is a direct or indirect result of the various stimulus packages, quantitative easing, cash-for-junk-vehicles and cash-for-junk-bond schemes, it follows that nobody can be sure whether or when it is safe to reverse the fiscal expansion.

But leaving it too late to retrench will hand the decision over to the bond markets. They will be looking for reassurance from the major debtor countries that both versions of the default scenario can be ruled out.

An outright default, probably camouflaged as debt renegotiation rather than repudiation, becomes politically more acceptable than the package of expenditure cuts and tax rises needed to carry on with repayments.

A more likely scenario sees the lenders repaid in devalued currency, as the debtor country achieves the same outcome by printing money so as to generate inflation –- an option always open to any country whose debts are denominated in its own currency (i.e. not to Eurozone members).

So far, the markets have given the United Kingdom and the United States the benefit of the doubt, trusting them to come up with a plan gradually to cut their spending over the next few years.

But how long before their patience is exhausted? The numbers are frightening even by the standards we have got used to bandying about during this crisis.

On the federal government’s own optimistic projections, the U.S. deficit will be around 12 percent of GDP this year, and will still be around percentof GDP ten years from now, by which time the national debt will have grown to over $9 trillion, or more than 75 percent of GDP, compared to just over 40 percent today.

For the UK, the projections are of the same order of size relative to the economy –- and based on assumptions every bit as optimistic.

Faced with numbers unprecedented in peace time, the danger is that the markets may start to doubt the resolve of either America or Britain or both. At that point, holders of UK and U.S. gilts could decide to dump their vast holdings, driving their price down and their yield up –- in effect, demanding compensation for their prospective default losses.

The cost of insuring against default on UK government debt in the credit default swap market is already over one half of one percent, an improvement over the last few months, but still more than double the comparable figure for France or Germany.

Ironically, the very fact that so many Americans are voicing their disquiet about government borrowing is one reason to be sanguine about the outlook for U.S. bonds and consequently for the dollar, though it is still hard to visualise a turnaround in the public finances on a scale sufficient to preserve the dollar’s long term status as the world’s reserve currency.

As far as the UK is concerned, there is virtually no prospect of any serious attempt to address the problem this side of the election, so the burden will fall entirely on the post-election administration. If, at any time in the next twelve months, Labour manages to recover in the polls to the point where a minority Government becomes a serious possibility, the gilt market could panic amid a flight from sterling.

Against this background, the key player at G20 will be China. Its leadership realised some time ago that its massive dollar reserves represent a $2 trillion hostage to U.S. political will, a costly error for which they will be thankful they do not have to face the wrath of the electorate.

If dumping its massive holdings of US Treasury bonds drove the dollar down by 30 percent, the cost to China would be about $600 billion, which nowadays sounds like small change. So far, the ultra-cautious Chinese leadership has been deterred by fears about the impact of a less competitive RMB (renminbi) on its exports, but at some point the prospect of replacing the dollar as the number one reserve currency might just prove too tempting to resist.

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