Since July 2008, the Chinese government has prevented the currency from strengthening against the dollar in an attempt to help Chinese exporters cope during the global financial crisis.
China's weekend "promise" is just enough to deflect criticism but status quo continues as the world tries to recover from tepid demand. Wal-Mart's recent comments about cautious projections illustrate the demand cycle is not fully back; even at less inexpensive price points. China might have dodged the G20 bullet right now but the world must adjust what is an unsustainable situation of over consumption from the developed nations and an oversupply from China.
Risk Trade to Rally
This is not a game-changer but more flexibility for the yuan is an overall good thing, and is likely to have a positive impact on risk assets and risk currencies, as well as global markets. It also means a costly trade war between China and the US is less likely.
Global markets are likely to welcome the move as it shows that China is confident that the global economy is strong enough to withstand any negative impact a strengthening yuan may have on China's export sector. This is important given that China is widely seen as the engine of global growth and crucial in steering the global economy out of the doldrums.
Commodity prices and currencies are likely to get a short-term boost as a stronger yuan increases China's buying power and therefore countries exporting heavily to China, such as Australia, New Zealand and South Korea, are likely to benefit most. The commodities sector have recently slowed down and China's move will provide the stimulus it needs to keep the flame going. Gold will likely benefit too given that investors are buying it more of a direct link to the weak US dolalr rather than simply a safe haven play.
But what does this mean for US Treasuries? If a risk rally does take place, this could lead to an unwinding of safe-haven positions, which would include US Treasuries. China making the yuan more flexible also could lead to speculation that China's demand for US Treasuries with fresh US dollar reserves is likely to stall or even decrease. Demand for corporate fixed income from companies like IBM and Berkshire Hathaway could surge as Treasuries lose appeal. (Follow the Dollar here)
China needs to park its extra cash somewhere and its likely to buy more euro-denominated bonds, and this is likley to put upward pressure on the euro and cause them further anguish as China is now forcing Europe to bear the burden of the imbalance rather than the US. If China buys German bunds, this will exacerbate pressures facing Germany. Spreads between German debt and other European debt could blow out. But can Germany now issue more debt to stabilize the other countries without experiencing inflation? That may be the outcome but it is unclear how the politics will play out.
The Shanghai Composite Indexhas tumbled 23% so far this year and this latest move is likely to provide an incentive for foreign investors to jump in. A more flexible currency regime will likely offer a much-needed shot in the arm for shares denominated in yuan. A stronger yuan will increase the buying power of Chinese companies leading to more attractive valuations.
Still, investors should react cautiously.
Any euphoria in the stock market is likely to be short-live given than any shift in the value of the currency is likely to be modest and conservative. Coming back on Monday, Chinese central bank set its daily reference rate at 6.8275 per dollar, unchanged from its reference point on Friday. Despite increasing international pressure to allow its currency to appreciate, China has again indicated it has very little appetite for a strong appreciation given the impact it would have on the competitiveness of its export sector.
Someone needs to bear the burden of rebalancing the global economy.
China clearly is interested in doing it's part. But as has been the case, they are opposed to carrying the full weight of this transitional burden. The rest of the world needs to take notice that their responsibilities are still present; and action must be taken soon to continue the global economic recovery.