G-7 Faces Vital Decision on Troubled Markets

LONDON -- The slide in global financial markets this year has raised expectations of urgent remedial action, but world leaders may find it impossible to deliver the goods when they meet this weekend in Naples. A flight out of the U.S. dollar and fears that European interest rates have bottomed out have driven the price of bonds sharply lower, raising the real cost of capital and so casting a new shadow over the prospects for sustained economic recovery. And unless leaders of the Group of Seven leading industrialized nations can improve on their recent record of all talk and little action, the damaging sell-off is likely to continue. "We have a slow-motion train wreck on our markets," said Christopher Potts, an economist with Banque Indosuez in Paris. Describing the situation as quite dangerous, he added: "The dollar is teetering on the verge of a real crisis. If nothing is done by Sunday night, it's going to get sold off in a big way."The dollar is critical. As long as it keeps falling, foreign investors will be reluctant to buy bonds and other assets to plug the huge U.S. balance-of-payments deficit, and American interest rates will tend to keep rising, pushing up the cost of money in other countries. "If no concerted action is taken, it is possible that the hemorrhage in bonds will continue," said Malcolm Roberts of Union Bank of Switzerland in London. He estimates that global investors have sold the equivalent of $600 billion worth of bonds already this year and said the possibility of a re-run of 1987, when a market crash panicked central banks into slashing interest rates, cannot be ruled out.The markets' favorite scenario has the G-7 summit triggering a coordinated shift in interest rates to pump cash into the liquidity-starved markets while bolstering the dollar. Germany and Japan would shave rates, while U.S. rates would be edged up. But the omens are not propitious. G-7 summits often fail to solve the burning issue of the day -- as was the case in 1992 and 1993 when world trade talks were stalled -- and there is no guarantee the three leading countries will agree on the dollar. Japan has a new, fragile government that may be unable to deliver promises to cut its trade surplus to rein in the yen. President Bill Clinton has denied that Washington is seeking a weak dollar to spur export-related growth but he has warned the Federal Reserve not to take "unusual actions" to brake the dollar's decline. And a top German official in Bonn said: "We should not give the impression that time has come for a major action. I do not know what action would be appropriate or sensible."Stephen Lewis of London Bond Broking said it was hard to be optimistic about Naples given the G-7's disappointing record. He said the slide in bonds -- already the sharpest since the outbreak of World War I -- would eventually peter out. But in the meantime, heavy government borrowing meant there was a stiff economic price to be paid for rising interest rates. "Higher debt-servicing costs will oblige governments to cut back spending in other areas. Lofty interest rates will also choke off demand in the private sector," Lewis warned. The seven -- the United States, Germany, Japan, Britain, France, Italy and Canada -- are widely expected to commit their central banks to stronger intervention to prop up the dollar. But Jim O'Neill of Swiss Bank Corporation in London said they would be better advised, as far as the yen is concerned, to sit tight until cash-rich Japanese investors are ready to start buying dollar assets again. He said this might be around the level of 95 yen to the dollar, compared with 99 currently. Indosuez's Potts agreed with O'Neill that intervention alone would not work and said altering market attitudes would be hard. But he said the G-7 could not afford to hide behind the belief that, because their economies were growing again without inflation, there was nothing fundamentally wrong. "The markets are trying to tell us something," Potts said. "The worst thing they could do at Naples is to congratulate themselves on a return to world growth. That would be dangerously complacent."