China’s fate in its own hands?

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Throughout this week China has been a talking point for markets, acting as a cooling breeze on risk trades. Initially, it was reports from BHP of the prospect of softening iron ore demand, but it remains in focus thanks to the softening of the latest PMI data overnight, showing the manufacturing series down to 48.1, from 49.6.

A China slowdown has been the dog that has not barked for some years now and China played a pivotal role in supporting the global economy through the 2008-09 slow-down. Video:

But this time the need for a rebalancing is widely acknowledged, by the Chinese leaders themselves.  The key question is whether this can be achieved in an orderly manner.  It’s not until the readings on Q1 output are available that the market will take a more pronounced view on this.  For now, FX is taking a more cautious approach, with the Aussie in particular proving vulnerable this week to the prospect of weaker demand from China.

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Commentary

The UK’s fiscal slippage.  The Chancellor’s budget speech was akin to listening to a summary of the newspaper reviews of the past two weeks, so much had been leaked and trailed beforehand. Whilst borrowing for the current year is forecast to come in GBP 1bln lower vs. November’s expectations, there has been some substantial slippage on the fiscal front compared to a year ago. Net debt (as % GDP) is now forecast to peak a year later (in March 2011) and at nearly 4% higher – at 76.3% in 2014-15, vs. 70.9% in 2013-14. The budget comparison was mostly concerned with the November autumn statement, against which today’s numbers were a modest improvement. The budget measures themselves were fiscally neutral, with most of the revenue-raising changes falling later in the forecast period. But there is also some uncertainty as to how they will stack up, especially the adjustment to higher-rate tax and other changes that will impact higher earners. The government’s own analysis shows that the revenue raised from the higher rate of income tax has been far less than the GBP 3bln assumed and the same uncertainties are likely to prevail with the changes to stamp duty on high-value properties and the related changes to company-held property. Delaying the cut in the 50p tax rate to April 2013 could well yield the government nothing, as many bonus and dividend payments will be delayed until the cut takes effect whilst pension payments receiving tax relief will be brought forward. In summary, the budget is not a major issue for sterling in the near-term, but ratings agencies could well struggle to continue to triple-A rate a country that is not assumed to achieve a sustainable debt burden for another four years. Of course, it can easily be argued that the impact would be minimal, as was the case in the US, but it will nevertheless be a bitter blow for the coalition government should it happen in the next year.

The decline of the yen.  The Japanese yen was again one of the weakest performers of the majors on Wednesday, USD/JPY pushing for a break above the 84.00 level on a sustained basis.  This further enhanced the weakening trend seen since the early part of February that has been helped by the easing of sovereign tensions in Europe together with incremental actions form the Bank of Japan aimed at boosting lending. The fear of intervention has been removed for the time being, with the authorities likely to be more than happy with recent developments.  Driving this has been a combination of interest rate-differentials working in favour of the dollar, together with higher oil prices bringing fresh fears that Japan may struggle to continue with year-on-year structural trade surpluses.  The 3mth rolling correlation between USD/JPY and oil has moved back into positive territory for the first time since July of last year.  Overnight, the yen has seen a modest correction vs. the dollar on the back of the first trade surplus for five months, although the 12mth average remains in negative territory.

Aussie under pressure once again. The Aussie was under further pressure towards the end of the European session and overnight, touching the 1.04 level.  The theme of this week has been renewed concerns regarding slower growth in China, which has carried through overnight with the release of softer PMI data from China.  But this is set against the agreement today between Australia and China to set up an AUD 30bln currency agreement. This marks at extension of China’s gradual steps to improve the international convertibility of the yuan.

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