The big story in the global foreign exchange markets for the past few years has been China's brazenly mercantilist policy of keeping exchange rates artificially under-valued and the reluctance of US and others to squarely call Beijing's bluff. Now, in an interesting twist, there is increasing evidence that China may be pursuing a different strategy with its exchange rate policy - diversification away from its hitherto dollar-centric purchases and investments into other currencies, mainly yen.
In this context, Japan's decision early this week to prop up the dollar and weaken its currency by intervening in international currency markets through sales of yen and purchases of dollars, assumes significance far beyond its immediate impact on the dollar-yen exchange rate. This intervention, the first since 2004, comes on the face of mounting pressure from export businesses who have been bruised by a surging yen which touched 83.66, the highest level since 1995. Faced with an economy fighting deflation and recession, the Japanese government is naturally concerned that the engine of its economic growth, exports, are being adversely affected by the strengthening yen.
This surge has coincided with China investing its massive dollar reserves into buying large amounts of yen-denominated Japanese bonds for the past few months, acquiring a net 583.1 billion yen ($6.97 billion) in July and more than $27 n so far this year. At $2.45 trillion (as on June), China possesses the world’s largest foreign-exchange reserves, mostly held in dollar assets, while Japan has the second-largest reserves at $1.01 trillion.
Interestingly, the Chinese purchases of Japanese bonds have been mostly of short-term instruments. This suggests a tactical approach, as China buys yen-denominated instruments in anticipation of a strengthening yen (which benefits the foreign investor, as he gets back more dollars for every yen invested). It leaves them with the flexibility to exit once the yen starts weakening.
The circumstances - both Japan and China wanting to keep their currencies from appreciating, and China wanting to diversify its forex holdings - provide for a convergence of interests of both China and Japan. Japan buys dollars and sells yen, while China offers a share of its massive dollar reserves and buys yen, which it in turn invests in Japanese bonds. In other words, China is using Japan as a proxy to invest its dollar reserves, and US currency market diplomacy gets diverted to Japan.
The Chinese yen purchases also contributes to the rising yen, thereby forcing Japan into buying even more of dollars so as to keep its currency from appreciating. In fact, China has gone beyond Japan, and has been also purchasing South Korean and Malaysian debt, in an effort to reduce its dollar exposure and also deflect attention from US criticism that it is manipulating its currency and building up dollar reserves that is weakening the US economy. And underpinning all these foreign currency debt incursions is the policy of keeping yuan pegged to a depreciating dollar (which ensures greater returns from investments in those appreciating currencies).
But within Japan there are concerns about the Chinese policy, especially its reluctance to permit Japanese and other foreign investors make purchases in its domestic financial market. This would enable Japan and Japanese borrowers exposed to Chinese investments hedge against sudden shocks (of say, yen depreciation, that can precipitate capital flight from yen) by taking corresponding yuan investment positions.
In recent months, the People's Bank of China has talked in favor of overseas financial institutions investing in Chinese bond market so as to promote greater use of the yuan in global trade and finance. But with China, such announcements mean little. In the last instance, since its high-profile announcement in June signaling that it would let the exchange rate start to reflect market forces, the yuan has risen exactly 1% against the dollar!