G-7 Pledges to Keep Stimulus Even Amid Budget Stress (Update3)

“The position for most countries is to support the economies now and get the budget deficit down as the economy recovers,” U.K. Chancellor of the Exchequer Alistair Darling , 56, said in an interview in Iqaluit, Canada last night. “You will see a determination from the G-7 countries to do just that.”

Governments are trying to spur expansion by spending at a time when Investors are increasingly shunning countries with rising debt burdens. The MSCI World Index of stocks fell to its lowest since October this week amid worries that Greece and some other European nations may default.

“Interest in Spain, Portugal, especially Greece was stronger than I expected,” Japanese Finance Minister Naoto Kan , 63, told reporters yesterday after the G-7 met for dinner and a fireside chat.

U.S. stocks rebounded yesterday as Investors speculated the European Union may craft a solution for its indebted members.

‘Dress Rehearsal’

Greece is struggling to persuade Investors it can restrain the EU’s largest budget Shortfall without outside assistance, while borrowing costs are also rising for Portugal and Spain. Deutsche Bank AG yesterday warned that the increase in the cost of insuring against default the debt of the peripheral European nations may be a “dress rehearsal” for the U.S. and U.K., whose own budgets deteriorated during the financial crisis and recession.

“There is always a danger that they wait until too late to shift their attention to the mounting red ink on their fiscal ledgers and risk losing all they tried to achieve in terms of restarting their economies,” said Chris Rupkey , chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York.

G-7 finance ministers are signaling a preference for keeping support for their economic recoveries while pledging to tackle their debt levels once growth is cemented. In a sign the U.S. rebound may be strengthening, a Labor Department report yesterday showed the unemployment rate unexpectedly dropped to 9.7 percent in January, the lowest since August.

“We are all agreed that continued stimulus is necessary,” Canadian Finance Minister Jim Flaherty , 60, told reporters. “There is a concern about deficit levels and, when stimulus ends, how we exit.”

Exit Strategies

“The crisis hasn’t yet been overcome,” German Finance Minister Wolfgang Schaeuble said in Iqaluit. “It’s about the right exit strategy. Europe isn’t the only one with budget problems.”

U.S. Treasury Secretary Timothy F. Geithner , 48, said Feb. 2. after the Obama administration forecast a $1.6 trillion budget Shortfall for this year, that while deficits are a “corrosive threat to our economic future,” boosting growth remains the “priority.”

Kan said yesterday that Japan would win “a gold medal without a doubt” for running the world’s largest debt, yet will wait until passing next fiscal year’s budget by the end of March before looking to contain it.

With the International Monetary Fund calculating debt in the advanced Group of 20 economies will reach 118 percent of gross domestic product in 2014, up from about 80 percent before the crisis, some G-7 nations are attracting the ire of investors and credit Rating companies.

Debt Ratings

Standard & Poor’s last month cut the outlook for its sovereign credit Rating of Japan, whose debt burden is approaching twice the size of its economy. Moody’s Investors Service Inc. said on Feb. 2 that the U.S.’s Aaa bond rating will come under pressure unless additional measures are taken to reduce deficits.

Nassim Nicholas Taleb , author of “The Black Swan” and a principal at Universal Investments LP in Santa Monica, California, said Feb. 4 that “every single human being” should bet U.S. Treasury bonds will decline, while Pacific Investment Management Co. calls U.K. government bonds “a must to avoid.”

Acknowledging the risks, a document drawn up by Canadian officials for discussion at the talks said G-7 members should set “clear, credible and consistent” plans to strengthen their budgets.

Delay in doing so would lead markets to “begin to question our commitment to sound medium-term policy frameworks, with the result that Interest rates would rise,” said the report obtained by Bloomberg News. “This would further complicate the challenge of re-normalizing monetary policy and introduce another source of uncertainty.”

Isolated Location

The G-7 officials are meeting 195 miles south of the Arctic Circle in a former whaling and fur-trading outpost that is now the capital of Canada’s northernmost territory, Nunavut.

Bank of England Governor Mervyn King , Italian Finance Minister Giulio Tremonti and Flaherty were among the delegates to try dog-sledding ahead of last night’s discussion of the economic outlook and the G-7’s role.

The Canadian government is hoping the isolation of the location will enable the G-7 to return to its roots as an arena for informal debate after the Group of 20, which includes emerging markets such as China, became the main arena for setting global economic policy last year.

Mobility

In another document prepared for the talks, Flaherty’s department said the G-7 remains relevant even with the rise of the G-20. It can mobilize quickly in a crisis, share views relevant to rich nations, act as a forum for aid-providers to discuss development and serve as a catalyst for ideas to be debated by the G-20.

The smaller group should still acknowledge the G-20’s enhanced status by reducing the frequency of officials’ meetings and dispensing with communiques unless necessary, the document said.

Highlighting the shift in power to the G-20, Kan said yesterday the larger forum is more appropriate for discussing the weakness of China’s yuan than the G-7. Flaherty said the issue of how some Asian economies have “relatively rigid currencies” was one that “cannot be avoided” if the world is to narrow international trade imbalances.

The G-7 discussion paper said countries with inflexible exchange rates should consider allowing them to strengthen without specifying particular nations.

Banking Regulation

Undermining the spirit of coordination are signs that governments are increasingly taking unilateral approaches toward bank regulation a year after they united to combat the worst crisis since the Great Depression.

The U.K. is imposing a one-time 50 percent tax on bank bonuses that France wants to mimic, while U.S. President Barack Obama is introducing a new bank levy and proposing limits on the size and proprietary risk-taking of large banks. Europe and North America are already at odds over whether to tax financial speculation.

Ministers today discussed ways of making the financial industry more resilient by forcing banks to increase capital buffers, a German finance ministry official told reporters. Officials also discussed the risk of fueling moral hazard, he said. Geithner told officials that the U.S. would only back some of the financial system, without extending that to cover hedge funds, according to the German official, who spoke on the condition of anonymity.

To contact the reporters on this story: Simon Kennedy in Iqaluit at skennedy4@bloomberg.net Simone Meier in Iqaluit at smeier@bloomberg.net