Market Review 22 June 2010

Last week was a better week ending with Saturday’s announcement that China intends to resume “reform” and “flexibility” in its approach to its exchange rate.  This announcement was taken positively today.  When the foreign exchange market opened this morning in the Far East, the reference rate for the Renminbi relative to the US dollar, initially left unchanged at Friday’s level, was allowed to strengthen to within touching distance of its 0.5% trading band. 

China has a crawling peg system whereby the Renminbi is permitted to move up to +/-0.5% against the US dollar per day but this 0.5% movement is against a mid point set by the People’s Bank of China.  Since September 2008, the People’s Bank of China has set the mid point in a way that prevented any meaningful movement either up or down. 

By making its announcement that it is now time to “continue with reform”, we assume that the currency will now start crawling upwards again.  A massive gain is unlikely.  Indeed, the non-deliverable forwards market now expects gains of a further 2.3% over the next 12 months.  The economic arguments within China against appreciation are well rehearsed.  Exporters are concerned about the sustainability of the global recovery. 

Meanwhile, inflationary pressures remain relatively low and the Renminbi, after all, has strengthened recently at least in trade weighting terms.  The nature of economic policymaking in China needs to be taken into account.  Having achieved consensus on the desirability of resuming appreciation against the US dollar, the People’s Bank of China will now have to demonstrate that the Chinese economy can withstand the currency moving at anything but a snail’s pace.  This will take time.

All that being said, the trend for Asian currencies should be higher.  To solve some of the world’s problems, Asian exchange rates will and must rise over the longer term and advanced nation currencies will fall relatively.  As it takes place, that shift will redistribute the balance of real wealth towards Asia but may cut sharply into their cost advantages for exporting and make imports into Asia a much stronger business. 

Asian exchange rates last week rose by the most in five months ahead of the G20 meetings next week.  Last week the won rose 3.6%, the Philippine peso 1.6% and the Indian rupee 1.4%.  The ringgit and the New Taiwan dollar both rose 0.8% last week with the Singapore dollar and the rupiah up 1.2% and the Thai baht rose 0.2%.  Thai exports in May rose 42% from a year earlier, the most since July 2008, despite political instability there. 

The 10-currency Asian exchange rate index, which excludes Japan, peaked most recently on 26 April, together with world stock markets at 113.24, after troughing on 2 March 2009 at 101.11, after a steep drop from 115.16 on 25 July 2008.  It closed up 1.0% last week at 111.02.

Another positive last week was the success of the Spanish bond auctions. 

Thursday’s Spanish bond auction of €3.5 billion of 10- and 30-year bonds was successful.  It was not cut back in size and was fully bid.  It was helped by record risk spreads over bunds.  The 10-year auction for €3.0 billion of notes had an average yield of 4.864% up from 4.045% at the previous 20 May auction and a bid-cover ratio of 1.89 times.  The 10-year yield closed down 12 basis points at 4.76% from Wednesday levels, which had been the highest in two years.  The €479 million 30-year auction had a 5.908% yield with a bid-cover ratio of 2.45 times. 

The 10-year risk spread had risen to an euro-era record of 221 basis points on Wednesday but fell to 209 after the auction.  Spain still has €24.7 billion of debt to redeem in July of which c. €16 billion takes the form of bonds.  The euro briefly topped $1.24 for the first time in three weeks. 

It would be hard to say we are out of the woods yet.  The Greek 30-year bond fell below 50 in price (to 48.85) for the first time since it was issued in 2007.  Its yield rose 42 basis points to 10.03%. 

Japan will hold elections on 11 July and the political parties are busily rushing out their policy platforms or manifestos. Prime Minister Kan has proposed faster economic growth, an end to deflation (but has avoided any mention of the yen exchange rate), a 10% consumption tax rate, up from 5% now, and targeting a number of industries and regions to help lead Japan’s growth.  

The yen rose against the US dollar last week.  The opinion polls, interestingly, show a surge in support, pointing to Kan winning his goal – a majority in the Upper House without coalition partners and a mandate to go to work on Japan’s serious budget and long term problems.

Kan has shifted the tax debate from the DPJ’s original policy manifesto of 2009 which called for no tax hikes for the first four years of their term in office. Given the LDP has set a “10% consumption tax rate for now” policy stance, the elections, therefore, will feature the two leading parties agreeing on a tax hike, a bit unusual. In effect, Kan has outmanoeuvred the LDP on this issue.  The second half of the child allowance increase will now have government “services” substituted for cash with additional cash payments “dependent on resources”.  In other words, it will probably not go ahead.

There is still a fight over the appropriate rate of corporation tax.  The government continues to hold to “cutting Japanese corporate tax rates down to world levels” as an important goal but has been unable to add details. The Ministry of Finance continues to oppose this (and many other past proposals), pointing to Kan and his budget deficit limiting policies. Japan’s corporate profit tax rate is 40% and the OECD 30-country rate averages to 26.3%.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30  years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.