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Monday September 18, 2006 - 01:01:14 GMT
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Forex: G7 Drops Annex Call For Higher Yuan, Agrees On Euro/Yen Overshoot

G7 Drops Annex Call For Higher Yuan, Agrees On Euro/Yen Overshoot

G7 did as expected and dropped its explicit call for a higher yuan in the annex statement added to the communique in April. However, it did repeat its April statement calling for a more flexible yuan, explicitly. The annex was blamed at the time for a broader dollar sell-off that in part gave a boost to risk aversion and saw emerging market currencies and bonds correct and so even going into the meeting few had the stomach for explicit calls for currency corrections.

That said the G7 remains unified in wanting to see a higher yuan. But in an new initiative, European and Japanese officials agreed that euro/yen had gone too far and implied it was not reflective of fundamentals. On Sunday the IMF also implied that euro/yen had overshot (yen bounce is a risk ahead for Japan's expansion along with a cooling US economy).

But with the FX market still driven by interest rates over imbalances, the scope for the yen to rally may prove limited. At the end of the day the BoJ needs to proceed with normalizing official rates and encouraging higher market rates and this is far from clear the course the BoJ has in mind in the next few quarters.

Several wire reports indicated that G7 chose not to name the yen in its communique because it would imply a call to intervene in FX and this is not the desire of officials. Indeed the message is verbally talk the yen higher. Or in practice encourage a market-led rise in the yen, versus the euro first and foremost. But despite silence from Treasury Secretary Paulson on the weak yen, Treasury is also inclined to see the yen rise versus the dollar in light of the US-Japan trade gap and pressure on US auto firms in particular who are losing market share to the likes of Toyota and Nissan, and so much so that the future of Ford is in doubt. Paulson has made fighting protectionist tendencies in Congress a top priority and while the debate rages on the yuan, it could swing to the yen in light of the trouble US automakers are facing. Hence no one on Washington is opposed to a market-led rise in the yen. And it is unlikely that Japan would have agreed that the yen was undervalued versus the euro unless the US Treasury agreed with the European finance ministers and central bank (Trichet was on board on the weak yen).

But if the BoJ fails to deliver on rates, where can yen strength come from apart from the initial news impulse markets provide Monday? The natural place is China and some new initiative to allow the yen to rise. But even Paulson said after G7 that he did not expect any immediate action from China on the yuan. Quoting the Treasury Secretary at the post-G7 press briefing, "I discourage high expectations for immediate results," Paulson said of his trip (to China this Tuesday through Friday)..."That's not the way the world works when you're dealing with important issues. I'm going to be listening." And in terms of a level in mind for the yuan he said, "I certainly don't have a specific target for China," he said. "That would be presumptuous of me."

So nothing from the BoJ and nothing from China on the yuan in the near-term. All euro/yen, and dlr/yen, have to drive a higher yen next week is verbal intervention. And no matter what Japan agreed to at G7, it has a history of checking market-led gains in the yen via verbal intervention ever since it ceased currency intervention in March of 2004.

Moreover, the stronger-yen trade already happened in early September when Germany's Deputy Finance Minister Mirow first raised the concern over the weak yen.

My take is the yen does rally on the news initially as markets open in Asia Monday. But a sustained rise in the yen will require more than recent mixed economic news from Japan, BoJ on hold, ECB tightening and G7 desire to see the yen rise. Ad my confidence in Japanese officials tolerating a sustained rise in the yen before the government of Japan has declared the end of deflation is wishful thinking.

David Gilmore


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