Markets on China Vigil as G8 Avoids Currencies, Surprises

Group of Eight finance ministers did not discuss currencies and gave no surprises at their weekend talks, leaving financial markets on Monday to take cues from swings in investor risk appetite from Chinese stocks.

The two-day meeting, which ended on Saturday, was overshadowed by Friday's surprise move by China to widen the yuan's trading band and raise interest rates ahead of key U.S.-China talks on trade tensions next week.

U.S. Treasury Secretary Henry Paulson was absent from the meeting in Potsdam and no minister attended from France -- where President Nicolas Sarkozy had appointed a new cabinet only on Friday -- making the meeting a low-key affair.

The communique was upbeat on the global economy, saying growth remained robust and more balanced, while risks to the outlook have abated. It made no mention of currencies and ministers said there was no discussion on foreign exchange.

This could fuel investor risk appetite, already at levels elevated enough to have sent shares to historic highs in recent weeks and boosted higher-yielding currencies, but a possible sharp fall in Chinese stocks on Monday could easily damage the upbeat mood -- as it did late in February.

"The G8 statement, in the very near term, could provide some stability after the wobble we saw on Friday. As long as equity markets remain stable, that should provide some renewed stability to the FX market," said Ian Stannard, currency strategist at BNP Paribas in London.

"It really does depend now on the Chinese equity market. We would see equity markets starting to come under pressure, risk appetite dampen down ... and the yen would recover on the back of that, particularly if the Chinese authorities allow faster appreciation of the yuan."

In February, Chinese stocks fell 9%, triggering weeks of turmoil across a range of global assets.

The yen rallied on Friday after China's move, a signal in the current trading environment that some risk is being taken off the table, though global stock investors held their nerve to help the FTSEurofirst 300 end the week at new 6-1/2 year highs.

Carry Trades

Mitul Kotecha, head of FX strategy at Calyon in London, said G8 officials lacked a clear focus or concern on carry trades.

"It gives the green light for carry trades to continue," he said, adding: "The focus will be the impact on Asian equity markets."

Japanese finance minister Koji Omi told reporters on Friday that foreign exchange rates should reflect fundamentals and should be set by free markets, echoing calls made by Group of Seven finance chiefs in Washington last month.

He also said his German counterpart had not expressed any concern about the strength of the euro against the yen.

The yen, which offers the lowest interest rates in the industrialized world, has been under pressure over the past year as investors borrow in the currency to purchase high-return assets and the euro has been a beneficiary.

International Monetary Fund chief Rodrigo Rato, who attended the G8 meeting, said on Saturday that investors should be wary of the risks of carry trades, adding that sudden changes can occur and usually do.

On China, finance ministers welcomed the move on the sidelines but urged Beijing to do more to boost yuan flexibility.

Elsewhere, the Canadian dollar could test a new 29-1/2 year high against the U.S. currency after Finance Minister Jim Flaherty said Canada's economic fundamentals are the strongest in the G7 and urged manufacturers to become more productive to shield against a strong currency.