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Markets to stay wary on stimulus after G20 pledge

Financial markets are likely to remain buffeted by uncertainty over government policy despite an unprecedented pledge by the world's top finance officials to cooperate as the global economy emerges from recession.

At a meeting in London at the weekend, finance ministers and central bankers from the Group of 20 nations said fiscal and monetary policy would stay expansionary as long as needed to ensure recovery.

That assurance could support fresh risk-taking in the markets this week, providing a moderate boost to global equities and prompting sales of the US dollar in favor of higher-yielding currencies such as the Australian dollar.

For the first time, the G20 officials said there should be some coordination of policies to avoid destabilizing economies when governments eventually start winding down costly stimulus schemes launched during the crisis.

This was important for long-term investors, who fear volatility in the currency and interest rate markets if some cash-strapped countries cut back fiscal spending and hike interest rates much sooner than others.

But the G20 did not explicitly address big issues blamed for imbalances in the global economy, such as the value of China's yuan. That raised questions over how much political will the group can really muster to coordinate policies.

And in some ways, the G20 seemed less united than it did when it met at the height of the crisis in April. While the April meeting produced a broad consensus on reform to financial regulation, the latest meeting bickered inconclusively over issues such as curbing excessive pay packages for bankers.

If the G20 has trouble setting common rules to regulate the finance industry, it may find it impossible to agree on sharing the fiscal burden of engineering a sustained economic recovery.

“The spirit of coordination is confidence-boosting, but in reality withdrawing fiscal stimulus will be difficult to coordinate,” said Lena Komileva, head of market economics for major developed economies at money broker Tullett Prebon.

“Investors still fear an uncoordinated exit could create stealth competition and contribute to increased volatility in government bond yields. It may be the fiscal equivalent of competitive currency devaluation.”

As the G20 met, there were fresh signs of improvement in the economic outlook. Documents obtained by Reuters showed the International Monetary Fund had revised up its forecast for the world economy this year and next.

It now forecasts a contraction of 1.3% in 2009, a bit better than its April forecast of a 1.4% shrinkage, and growth of 2.9% in 2010, revised up from 2.5% previously.

But the strengthening outlook carries its own risks; facing less pressure to cooperate urgently to avoid a global economic collapse, G20 nations may focus more on narrow national interests as they plot “exit strategies” from stimulus steps.

That may explain why G20 policymakers said almost nothing specific at the weekend about the “cooperative and coordinated exit strategies” which they promised. Instead, they merely said they would work with the International Monetary Fund and the Financial Stability Board, an international forum, to develop such strategies.

Asked if coordination meant central banks might hike interest rates in unison, just as they cut together during the crisis, British finance minister Alistair Darling simply said countries did not have to do things on the same day, but did have to work together to ensure they did not hamper recovery.

British Prime Minister Gordon Brown said sustaining the economic recovery would mean “avoiding unsustainable imbalances between countries,” such as trade imbalances.

But once again, the G20 did not make any concrete statement on adjusting the exchange rates of the dollar and the yuan, which are among the biggest factors affecting trade flows. China, with the sustainability of its recovery still uncertain, is not expected to let the yuan appreciate much any time soon.

Analysts believe uncertainty about how the global recovery will be managed may partly explain the surge of the spot gold price to near record highs over the past two months.

During the same period the CBOE Volatility Index, a measure of investors' willingness to take on risk, has stopped trending lower after sliding almost continuously since early this year as financial markets recovered.

The index is roughly where it was just before Lehman Brothers collapsed last September, but remains well above levels that prevailed in the years before the credit crisis began developing in 2007.

Sarah Hewin, senior economist at Standard Chartered Bank, said some investors were hoping for clear information from the G20 meeting about how exit strategies would be carried out, and would be disappointed that there was none.

“We should see more good news on the economy in the near term and those economies that have yet to move into positive growth, such as the United States and Britain, should see positive growth in Q3,” she said.

“But the issue is that some of the stimulus is going to run out, so the markets are likely to continue fluctuating between optimism and caution.” (Reuters)