Japan and China: Small Beer

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The main financial development over the Christmas holiday was an apparent agreement between Japan and China on a wide range of financial issues. The two key aspects are an effort to settle more of the bilateral trade in yen or yuan and that Japan will apply to buy Chinese bonds next year.

Japanese officials had already signaled interest in buying Chinese bonds. Contrary to what several press reports intimate, this is hardly an meant to diversify reserves. Recall Japan's reserve holdings at over $1 trillion are the second largest in the world behind China.

The fact of the matter is that China's bond market is simply too small to absorb the scale of funds that would be necessary for Japan to meaningful diversify its reserves. The entire Dim Sum bond market, which has captured the imagination of many investors and observers, has a market cap of about $30 bln.

If Japan's interest in Chinese bonds is not for diversification purposes, what is going on? Japan wants market intelligence. It can achieve this by quite modest investments of a couple hundred millions dollars, not billions or tens of billions.

Japan also wants access to China's capital markets because China has access to Japan's capital markets. Japanese policy makers seem ambivalent about Chinese purchases of Japanese securities, which some see as exacerbating the destabilizing appreciation of the yen.

Note that a number of countries are interested in securing Chinese permission to buy yuan bonds. Thailand, Nigeria, Chile, and Malaysia have been frequently cited in the press.

Trade settlement is a different issue. China is Japan's largest trading partners. Annual two way trade is near $350 bln and has grown three-fold over the past decade.

According to data from Japan's Ministry of Finance, Japan exported JPY10.8 trillion of goods to China in the Jan-Nov period and imported about JPY12 trillion. The JPY1.2 trillion deficit is about 3 times larger than the Jan-Nov 2010 period. Reports suggest that 60% of the trade was settled in US dollars.

It is clearly in the interest of Japanese and Chinese businesses to settle more trade in their own currencies. Yet few media accounts seem to grasp the difficulty. Consider it from a Japanese exporter point of view. They would likely prefer being paid in yen, which is a relative strong currency.

What would they do with yuan? What can they do with yuan? The Dim Sum market is not just small, but it is not very diversified as the main issuers tend to be Chinese government arms or real estate/property developers.

The Dim Sum bonds are also of short duration--three years and less--and are expensive as the yuan in Hong Kong (CNH) has grown significantly faster than the Dim Sum market. Moreover, the ability to convert CNH into CNY is tightly regulated.

A Japanese importer may be more willing to pay in yuan, but where is this yuan going to be acquired ? CNH can be purchased in Hong Kong. Over the last few months, CNH has been selling at a discount to CNY, but this seems more like an anomaly.

The offshore speculation of yuan appreciation has cooled as Chinese officials are seen shifting from fighting inflation to supporting the economy. Yuan appreciation is seen as more desirable when inflation is a major policy concern.

Chinese importer and exporter preferences may be for yuan, but even here it seems reasonable to suspect Chinese companies may be more eager for diversification. It is not clear, from a central bank perspective that increasing the trade settled in non-dollar currencies, even yuan, eases the complicated sterilization process.

Some observers have compared this sterilization process to a gigantic quantitative easing exercise. Recall the central bank accumulates foreign currency reserves. It purchases them by issuing bills and bonds.

The overwhelming majority of global trade is invoiced in US dollars and euros. This does not mean that other currencies are not used; merely that the use is modest in scale. There are various benefits, alongside inertia, that explains the use of the dollar and euro as invoicing currencies. Also, most commodities are priced, traded and invoiced in US dollars.

Some observers who see the decline of the US everywhere will seize upon the news of Japan and China's initiative as more evidence of the end of US hegemony. This seems to be a stretch. Japan is not moving in China's orbit. Unlike many observers appreciate, they recognize each other as rivals.

Understanding the financial agreement within the context of that rivalry is more important than what it means for the future of the dollar as the world's more important reserve currency, invoicing currency and vehicle currency. Nor will the agreement impact the outlook for either the yuan or the yen.