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By Rom Badilla, CFA – Bondsquawk.com

This past weekend, the People’s Bank of China announced that they will allow for a more flexible currency. Though, the statement was rather vague as to the degree of the amount of appreciation it will allow. The details have yet to be revealed but if anything, we can expect a very small appreciation in the short term which isn’t exactly what the U.S. had in mind. While the statement is a positive gesture, the Chinese government has a long way to go in the minds of the U.S. in correcting this imbalance. Hence, the statement is exactly that and nothing more than just a gesture.

The statement comes before the G20 meeting where U.S. and Chinese officials were in for a showdown on future prospects for the peg. China doesn’t want the G20 meetings to focus on the currency peg and prefers to press other issues such as the European debt crisis and rising budget deficits for developed countries. With this announcement on the table, it alleviates pressure from the international community for meaningful currency reform and buys more time.

The truth of the matter is that China is reluctant to allow for a sizeable move in the yuan since it has already seen the currency appreciate with the decline in the euro, limiting Chinese exports to the region. Further declines in the euro due to the deterioration of the European fiscal situation may alter China’s plan of allowing considerable appreciation for the yuan. Also, a vigorous appreciation against the dollar will hurt Chinese exporters in the short term and ultimately turn the focus to China in becoming a more consumer-driven economy. While such a goal is desirable over the long term with signs pointing that way in the form of workers demanding higher wages, China is still in the process of evolving and isn’t quite ready to make the jump yet. Truth be told, China cannot turn back years of a culture built on savers and underconsumption overnight (the same can be said about changing U.S. bias toward over-consumption and spending beyond their means).

As far as the U.S. markets go, the announcement should fuel advances in equities as bulls argue that a stronger yuan should bode well for future growth for U.S. multinationals. Companies like Caterpillar, which is the world’s largest maker of construction equipment and exports heavily to China, would benefit over the longer term as goods become cheaper for Chinese industries and consumers. Such prospects could create optimism for growth in the second half of this year and give reason for the bulls to run. Also, this could lead interest rates to the higher end of the recent range fueled by future growth prospects and higher inflation expectations.

Unfortunately, the benefits to U.S. multinationals from yuan appreciation, assuming China follows through and the appreciation is relatively small, will not be noticed in the short term. The fact remains that the U.S. stands on shaky ground and the probability for a slowdown appears real for the second half, as evident by the recent spate of weak economic data such as high initial jobless claims, low non-farm payrolls, and anemic retail sales figures. Leading indicators such as ECRI has dropped and is on everyone’s radar screen for a possible signal for another dip in economic activity. In addition, the massive amounts of debt in Europe are still present and will take center stage again at some point as countries like Greece and Spain dance on the edge of either a default or restructuring. Prospects for a shift in currency policy by China cannot make the deep-rooted problems of the developed economies suddenly disappear. As a result, U.S. stocks and bond yields could resume its downward trend once euphoria wears off from the news from China.

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