China --Under-whelming

There is one main talking point today: China. On Saturday, the PBOC noted on its web site that it was reforming the yuan’s mechanism for greater flexibility, but that it was not altering the 0.5% band against the dollar and did not see the necessity of a large move. The statement also seemed to upgrade the importance of its trade-weighted basket and downgrade the importance of the dollar-peg. This note was followed on Sunday with another note, written in a Q&A format that seemed to reassure a domestic audience that the currency move was not going to be very significant. The other element that some observers have emphasized is that the PBOC tried to explain the move as in China’s self-interest.

The market’s response was nearly euphoric. Asian currencies rallied. Emerging markets rallied, with the MSCI Emerging Markets Index staging its biggest rally in 3-weeks. Commodities rallied. The 12-month non-deliverable forward implied expectations for about a 2.3% advance over the next year. The yuan appreciated in the spot market by about 0.4%, which appears to be the biggest single day gain since July 2005.

The market could be setting itself up for disappointment. Chinese officials have cautioned against expecting a significant move. It did not alter its reference rate today (CNY6.8275). Flexibility can have different meaning. When many international observers talk about flexibility they mean the flexibility to allow the yuan to rise. Chinese officials have signaled a different meaning. That is a better two way market. Some Chinese officials have intimated the yuan may not only rise but decline as well.

The Chinese move has won supportive comments from various governments. And this may show the tactical value of the China’s announcement. Even though nothing has really changed, China has unilaterally changed the agenda, even if the informal one, for the upcoming G20 summit.

Ahead of the April 2009 G20 meeting the PBOC posted on its web site, a call by its head for international monetary reform that would replace the dollar with the SDR. Not very much has really materialized (though there was a new SDR allotment, which would have taken place in any event). On one hand, the equity, commodity and emerging markets are have responded as if the Chinese announcement was significant. On the other hand, the 12-month NDF at 2.3% is below levels that were seen in early May, suggests a market that is under-whelmed.

The euro recorded its session highs in pre-Tokyo Asia just shy of $1.25. The session low around $1.2368 was recorded on the disappointment that the yuan-fixing was unchanged. The euro had recovered from the shock but was unable to make a new high. It was trading near $1.2440 when European markets opened and fell to about $1.2390 before its descent slowed. A break of $1.2355 and especially a close of the North American session below there would be the first sign that the euro’s bounce off the 7 June multi-monthly low near $1.1877 was tiring

While there is much focus on tomorrow’s UK budget tomorrow will see the Spanish parliament vote on the labor reforms announced by Prime Minister Zapatero on 16 June. The labor reforms are thought to make it easier to hire workers, but at first it may make it easier to dismiss them. Severance payouts, for example, in some areas may be cut to 25 days compared with the current 45 days. Workers will be able to be more easily laid off temporarily. Zapatero heads up a minority government and last month’s much-heralded austerity program was approved by parliament with a single vote.

Mixed signals are emanating from Japan ahead of the government’s growth and budget strategy that is expected later this week. Leading DPJ officials had seemed to be pushing for a doubling of the retrial sales tax to 10%. However, Prime Minister Kan told the press today that it could take two or more years to implement it. Recall last week, the retail sales tax increase discussed in the context of financing a corporate tax cut. The DPJ may want to tread carefully, it would seem, ahead of the 11 July upper house elections. The latest poll in a local paper showed the new prime ministers support has fallen to 50%, down 9 percentage points in the past couple of week. The public seems split on sales tax issue. Meanwhile, Fitch warned that Japan’s sovereign AA- rating may be vulnerable without a credible fiscal strategy by the end of the year.