G7 meeting: FX, reform and oil: Mostly words, little action

At the G7 meetings in Washington, there were three areas of focus of market importance. First was the focus on the need for FX flexibility for major economic regions. Aware that this criticism is implicitly aimed at its FX framework, China reiterated it would move towards a more flexible FX regime. But PBOC governor Zhou Xiaochuan said the depegging of USD/CNY will not come in the near term, given the technical difficulties in liberalising its exchange rate. Pressure from the US on China over this issue will remain high, but Beijing will treat exchange rate as a domestic affair and is unlikely to change its current arrangement simply to placate its trade partners.

Second on the agenda was the need for reform with the focus on trying to correct global trade imbalances, which G7 nations said is a shared responsibility. For years, the emphasis has been on Japan and Europe to strengthen their domestic economies in order to take the pressure off the US economy as the sole major source of global growth. This pressure remains. But now, the US is under pressure to prioritise medium-term fiscal consolidation. The twin deficits are likely to remain a huge concern for financial markets and the USD well past the Presidential election next month.

Finally, G7 officials called on oil producers to ensure adequate oil supplies given the risks that high oil price pose for global growth. The price of WTI crude averaged almost USD44 per barrel (pb) in Q3-04 after USD38.40 in Q2 despite a recent easing of the fundamentals. The price reflects nervousness over limited spare capacity against a background of strengthening demand and heightened geopolitical tensions. The long-standing empirical relationship between US oil stocks and prices has broken down this year, as scarcity has become an issue. Moving into Q4 and the Northern Hemisphere winter, we expect prices to remain at least as firm.

We have raised our forecast for Q4 prices to USD45 pb, bringing the average for 2004 to USD41 pb. Rising capacity, increasing evidence of higher stocks, and more moderate global growth should allow prices to ease through 2005, but demand will remain firm. Consequently we expect prices to fall back, but remain well supported. Our 2005 forecast for WTI is US$38 pb. OPEC action is key to this forecast, as we expect the cartel to continue to produce at a high rate through the seasonal downturn in Q2 05 to allow global stocks to build.