Time is running out for the G7

The Starr Report may distract officials from their mission to repair the global economy, says Peter Koenig

WHEN THE Group of Seven meeting called by Tony Blair in response to the Russian crisis begins in London tomorrow, much of the City will be distracted. The Starr Report on Bill Clinton's relations with Monica Lewinsky will transfix markets as much as it is transfixing the world.

But the City will not be entirely distracted from the G7 meeting, and the observers lining up to watch are pessimistic.

Paul Donovan, senior international economist for Warburg Dillon Read, will be looking for concrete steps to forestall global deflation. Pippa Malmgren, London currency strategist for BT Alex Brown, wants to see if anyone shows up. "The word I'm getting from Washington and Tokyo is that people are ducking coming to the meeting," she said. "No one thinks anything will be accomplished. People are worried they'll be blamed for the market's disappointment."

Mohamed El-Erian - the European head of emerging markets at Salomon Smith Barney who until recently worked for the IMF's deputy managing director, Stanley Fischer - takes a more balanced view. "I can tell you what the meeting will not be about," he said. "It will not be about solving Russia; it will be about fencing Russia." But he adds: "Anybody who expects a solution to the deepening global crisis will be disappointed."

There is little reason to be other than pessimistic. The sell-off in shares in the City and on Wall Street on Thursday demonstrated there is yet no obvious sense of bottom to the bear market. The prospect of a US president fighting impeachment through the autumn only deepened the gloom on Friday.

Pessimistic or not, the City will still be hoping against hope that the G7 meeting tomorrow at least begins a process culminating in two accomplishments:

Saving emerging markets - Russia, the Asian tigers, Brazil, and the rest of Latin America - as an asset class; and

Stabilising the international financial system. "Investors are on the defensive now," said Ms Malmgren at BT Alex Brown. "They're not thinking about making 20 per cent or 2 per cent. They're thinking about how they can avoid losing money."

No one in the City is giving the G7 meeting tomorrow more credence than it deserves. "As rotating head of the G7, Blair called it after talking to Clinton in Northern Ireland so the policy-makers could be seen to be doing something," said Ms Malmgren.

Yet if the meeting is artifice - if policy-makers could just as well have talked informally - the agenda is real.

Russia looks less politically convulsed this weekend than it did last. It seems all but certain there will be a new government in Moscow formed round Yevgeny Primakov, the foreign minister and former KGB spy.

But the drift of events beyond Russia looks worse this weekend than last. "All kinds of wealth is being destroyed in all kinds of ways," said Mr Donovan. "The policy objective tomorrow must be to stimulate global demand."

Until a month ago, G7 leaders were engaged in bitter but still fraternal bickering. But they agreed on fundamental global strategy:

To deregulate the global financial system so capital can move freely from Silicon Valley to Shanghai.

To export the Anglo-Saxon model of economics to Asia, Latin America, and Eastern Europe, where booming birth rates and pent-up consumer demand will underpin growing world trade.

To use the International Monetary Fund to administer medicine and distribute Western taxpayers' money when one or another country goes walkabout economically and private investors flee.

This consensus view has now been discredited. Too many emerging market countries have gone walkabout. The numbers don't add up anymore. The IMF is almost broke.

None of this will be addressed in plain language at the press conference following the G7 meeting. But the City's tea-leaf readers will be ready to read between the lines of any declarations - both in terms of hinted changes in national policies and in terms of the group acting together.

Chief whipping boy within the G7 will continue to be Japan, the world's second largest economy, which has come under sustained US attack for neither stimulating its economy sufficiently, nor consolidating a banking system dragged down by $500bn in bad debts.

On Wednesday, the Bank of Japan said it would ease monetary policy further by reducing a key interest rate from about 0.5 per cent to 0.25 per cent. The corresponding interest rate in the US is 5.5 per cent. The City remained jaundiced.

Analysts noted that US Treasury secretary, Robert Rubin, and Japanese finance minister, Kiichi Miyazawa, met in San Francisco last weekend. They said Japan's interest rate reduction was an insignificant move to get the Washington monkey off Tokyo's back.

There was a second, more downbeat interpretation. "There's a rumour that one of the big Japanese banks went to the government and said that unless it got some relief, it would close its doors," said BT Alex Brown's Ms Malmgren.

The City will look for hints about a new allocation of funds for the IMF from the G7. Chief reprobate here is the US. The Congress has long balked at approving a Clinton administration bill for $18bn in fresh IMF funds. But with 445 pages of the Starr Report circulating on the Internet, the US President has little leverage to pressure Congress into an act of international statesmanship.

Yet the IMF remains one of the few bulwarks against financial chaos. If it goes, there is nothing left except the US Federal Reserve Bank, the Bundesbank and, to a far lesser extent, the central banks of the other industrialised nations.

The City must wait to see what hints from the G7 meeting emerge about a co-ordinated reduction in interest rates. "Preparations for co-ordinated easing of monetary policy are absolutely essential," said Mr Donovan.

There were rumours in the City last week that a co-ordinated cut could come as early as this week. But this could well be wishful thinking. Co- ordinated interest rate cuts remain the jet-fuel of policy-makers seeking to direct markets.

The G7 might save this weapon for an even darker day. But more likely is a guarded U-turn from the G7 on restrictions on the free flow of capital globally. In lieu of any other measure, this remains a possibility for stopping the contagion of panic spreading from one emerging market to another.

The G7 will be watching Brazil from London tomorrow. The fear is that the speedy walk toward the exits in Brazil by private investors will turn into a panicky stampede. The IMF does not have the $50bn to loan to Brazil that might persuade investors in the cruzeiro and Brazilian shares to stay in place.

Therefore, according to Washington sources, the G7 may rewrite Commandment Number One: Thou Shalt Never Impede the Free Flow of Capital. Officials are not about to endorse the crude restrictions slapped on trading of Malaysia's currency by the Prime Minister, Mahathir bin Mohamed.

However, there is a debate taking place over whether the Hong Kong Monetary Authority was clever or stupid to spend $15bn to support the Hong Kong stock market in the face of the attack on Hong Kong shares by hedge funds.

Warburg Dillon Read's Mr Donovan thinks the HKMA was stupid. "The HKMA has seen off the hedge funds for now. But by intervening, it signaled it has a pain threshold. The hedge funds will be back," he said.

In a paper delivered at the British Association meeting in Cardiff on Thursday, University of Warwick economists Marcus Miller and Lei Zhang wondered if Hong Kong officials got it right. As the old system for conducting international economic policy breaks down, they suggested, it may make sense for government to adopt new tactics.

While the City hopes there will be news of a co-ordinated interest rate cut emerging from the G7 meeting tomorrow, the actual news may be different. The G7 officials may tacitly approve the imposition of capital controls by Brazil when only a month ago this would have seemed impossible.

Such news would signal that we have moved into a new phase of the post- Cold War era. It would be received with alarm in the City, the cockpit for those moving capital round the world. People would fear for their jobs as the empty seats appearing at Asian and Russian emerging market desks spread to other parts of City trading floors.

But the news need not be all bad. If the Clinton administration, humbled by domestic events, were also to tone down its post-Cold War triumphalism; if it were to moderate its belief that it knows best for the world economy - the resulting signal could be good for confidence in global markets.

The scaling-down of American power inside the G7 would be bad if it created a vacuum. A vacuum at the top is what the markets sense now. It is what is spooking the City.

The trick then will be for Europe and Japan to assume greater responsibility for managing the global economy.

"Think of it this way," said one City analyst. "There has been an implicit contract in the post-Cold War order. The US looks after Latin America. Germany looks after East Europe. Japan looks after Asia.

"That contract is not working, which is why there is a global crisis. The contract needs to work. Time to make it work is running out."

But speculation about the impeachment of the President of the United States is hardly going to inspire confidence that the G7 can work something out.