Wed, Oct 01, 2003 - Page 9 News List

G7's devaluation gamble might backfire rapidly

By Faisal Islam  /  THE OBSERVER , DUBAI

Maybe it was Dubai's 41?C heat. Or perhaps they were inspired by the grandiose engineering projects, such as the first underwater hotel, or the 200 artificial holiday islands shaped like a map of the world.

Whatever it was, over the past week the globe's most powerful finance ministers have shown hitherto unknown creative faculties.

Extraordinary attempts to rebalance world economics with a new version of the Plaza accord (the 1985 agreement that lowered the dollar's value) ventured into uncharted territory when the G7 backed the desirability of "more flexibility in exchange rates -- for major countries or economic areas."

It doesn't sound much, but in effect the US persuaded the finance ministers of the other six major industrialized nations to back its efforts to put the screw on China, whose policy of keeping down the value of the yuan is hurting the US economy. Beijing buys about US$10 billion a month to fix the yuan at roughly 8.28 to the dollar. A powerful lobby in the US blames cheap Chinese exports and its "manipulation" of currency markets for manufacturing woes and has put its case to US President George W. Bush.

"It's one thing for China to say no to America, but to say no to the G7 industrial countries collectively would be more difficult," says Jim O'Neill, an economist at Goldman Sachs.

It was a triumph of US financial diplomacy, according to Secretary of the Treasury John Snow, yet it may backfire spectacularly. Currency markets were turbulent last week, initially granting the G7 its wish by sending the dollar plunging to three-year lows against the yen, and pushing it well down against the euro. But stock markets in Japan, Europe and the US also fell sharply. Had Snow drop-kicked the "strong dollar policy" to the bottom of the Arabian Gulf? Did the finance ministers really agree on who they were targeting?

In fact, almost every country around the table had a different interpretation of what they were signing up to. The Americans thought the text was about China. The continental Europeans thought it was about the Americans. The British thought it wasn't really about anybody. And the Japanese assumed it was about the Europeans.

Snow said the decision was a milestone. The US manufacturing lobby was cock-a-hoop. The US could be seen to be doing something robust about the supposed causes of its jobless situation. Meanwhile, the communique gave IMF Managing Director Horst Kohler an excuse to bash the US for not adopting Europe-style "credible" fiscal rules.

The Japanese, who are the most worried about China's competitiveness, were glad to see pressure on their neighbor. But a senior Japanese official said privately that the reference to "economic areas" was about the EU, suggesting it should be constrained from any attempt to bring down a rising euro.

Japan's approach at the meeting had backfired spectacularly, at least in the short term. All the pressure was placed on the yen as it soared upwards, increasing China's competitiveness. Traders were left wondering exactly when the Bank of Japan would re-enter the market.

Back in Dubai, the currency message was backed with an imaginative "growth agenda." Snow and Gordon Brown had agreed at a breakfast in the summer that each country should outline specific steps to restore confidence in the world economy. Yet this agenda is risked by the US strategy.

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