`Traumatized' G-20 Delays Rate Rises as Europe Debt Crisis Rattles Markets

Group of 20 central banks are delaying their withdrawal of emergency stimulus as Europe’s debt crisis shakes financial markets and threatens to hinder the global recovery.

G-20 finance chiefs begin talks today in South Korea after central banks from Australia to Canada identified investor reaction to Europe’s indebtedness as a hurdle to higher interest rates. European Central Bank President Jean-Claude Trichet has reversed his exit strategy to combat the euro’s biggest test, while the Federal Reserve’s Charles Evans and Dennis Lockhart signaled market stress will delay a rise in U.S. rates.

“Given the increase in uncertainty in the economy, it would be perfectly natural for people to be less eager to tighten,” William White, a former Bank for International Settlements chief economist who pointed to risks in financial markets before the 2008 credit crisis, said in an interview in Seoul.

The need for central bankers to keep rates lower for longer may spark tension in Busan, South Korea, as monetary policy makers intensify their public demands for fiscal authorities to restrain debt in return. The pressure is an echo of the 1990s, when then-Fed Chairman Alan Greenspan and counterparts lobbied leaders to narrow deficits that threatened a bondholder revolt.

Europe’s Rescue

Trichet, Chinese Finance Minister Xie Xuren and their G-20 counterparts convene today for the first time since a Greek-led sell-off in the bonds of the euro-area’s most indebted nations spurred the European Union to craft a 750 billion-euro ($918 billion) rescue plan and the ECB to buy the bonds of “dysfunctional” markets.

The package hasn’t been enough to pacify investors concerned sovereign debt is the biggest threat yet to the recovery from last year’s global slump.

The MSCI World Index of stocks has fallen 12 percent since mid-April and the rate banks say they pay for three-month loans in dollars last week reached the highest level since July. The market for corporate bonds closed on June 1 as concern European banks will take more writedowns and losses led investors to shun all but the safest government debt.

“Investors are going to stay cautious,” said Andrew Milligan, the Edinburgh-based head of global strategy at Standard Life Investments, which manages the equivalent of $214 billion. He predicts they will seek “ballast” for their portfolios amid volatility by buying investment-grade corporate debt. Bonds from governments with lower borrowing levels will also outperform, he forecast.

Credit Crunch

Central banks are concerned the biggest threat to the recovery is banks ceasing to lend and financial markets freezing as happened in 2008, rather than weaker European demand, said Julian Callow, chief European economist at Barclays Capital in London. He estimates Greece, Ireland, Portugal and Spain accounted for just 4 percent of world gross domestic product last year.

“They are traumatized by what happened in 2008,” said Callow, who previously worked at the Bank of England. “Investors are nervous again so central banks are picking up on that.”

Trichet’s ECB is leading the pullback, announcing May 10 it would intervene in markets to buy government bonds, renew its auctions of unlimited cash to banks for up to six months and revive a currency swap line with the Fed.

Shifting Forecast

Goldman Sachs Group Inc. Chief European Economist Erik Nielsen now expects the ECB to wait until the second quarter of next year to raise its benchmark rate rather than during the first three months of the year as he previously anticipated.

Other G-20 central banks are also taking note of Europe’s woes. Australia kept its key rate at 4.5 percent on June 1 and signaled it may leave it there for the “near term,” noting in a statement that “investors have generally displayed a good deal more caution.”

Turkey’s central bank said on May 18 that indebtedness elsewhere in Europe means “uncertainty over external demand is likely to remain important for a long time.” Russia’s Bank Rossii cut its main interest rate for the 14th time in as many months on May 31 to support its recovery, while Indonesia yesterday kept its benchmark unchanged at a record low.

‘Extended’ Period

Fed Bank of Chicago President Evans said May 31 he “wouldn’t be surprised” if the Fed’s policy of keeping rates near zero “gets extended just a little bit.”

Atlanta Fed President Lockhart said yesterday that “the pressures in Europe may slow the movement toward any removal of accommodation.” Bank of England policy maker Adam Posen said in a May 20 interview Europe’s crisis is going to inflict “some negative drag on the U.K.”

“If you have volatility in markets and implications for the financial system then central bankers are going to be concerned about the risks to growth so may be relatively more conservative in scaling back support,” said Paul Donovan, a UBS AG economist in London.

Even central banks that have raised rates may now be slower to do so. In India, where the Reserve Bank increased borrowing costs in March and April, Deputy Governor Subir Gokarn last month said officials will be more cautious with future moves. Bank of Canada Governor Mark Carney mentioned Europe and its crisis four times in a one-page statement on June 1, a signal his bank may not soon repeat its quarter-point rate rise.

Brazil Exception

Brazil, where inflation has exceeded the government’s target each month this year, may be an exception. Brazil central bank President Henrique Meirelles said the nation’s policy makers are in a “tightening mood.”

“We are committed to keeping inflation on target,” Meirelles said today in a Bloomberg Television interview from Busan.

The market jitters may also have given China reason to refrain so far from letting its currency rise against the dollar. G-20 members have repeatedly called for an end to the peg China adopted in July 2008 to aid its exporters. The euro’s 15 percent slide against the yuan this year already threatens to undermine Chinese shipments.

Twelve-month non-deliverable yuan forwards reflect bets the yuan will strengthen 0.7 percent from the spot rate of 6.83 per dollar compared with projections of a 3.2 percent appreciation at the start of May.

China’s Yuan

“China’s economic strength certainly justifies a stronger yuan and higher interest rates, but policy makers don’t want to give an impression that they are tightening at a time when exporters are suffering,” said Tomo Kinoshita, an economist at Nomura Holdings Inc. in Hong Kong.

In return for doing more to aid expansion, central banks may demand governments work harder to outline and enact plans to narrow budget gaps, with southern Europe an example of what may happen if they fail. Citigroup Inc. economists estimate G-20 governments must tighten fiscal policy an average of 8 percent of GDP over the next decade to reduce debt burdens to 60 percent of GDP.

Trichet said May 31 that he will no longer tolerate a lack of budget discipline in the euro area after all but Luxembourg and Finland last year violated a rule to hold budget deficits to less than 3 percent of GDP. Fed Chairman Ben S. Bernanke said April 27 that a failure to reduce the U.S. deficit may imperil the recovery by pushing up borrowing costs.

Finance ministers headed to Busan seeking to juggle the goals of protecting growth and consolidating budgets. U.S. Treasury Secretary Timothy F. Geithner said he wanted fiscal reform that was “growth-friendly,” while France’s Christine Lagarde said the G-20 was aiming to restore confidence in public borrowing, yet not “suffocate growth.”

To contact the reporters on this story: Simon Kennedy in London at skennedy4@bloomberg.net; Shamim Adam in Busan, South Korea, at sadam2@bloomberg.net

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