Renminbi-Yen-Dollar Collision Course

Currency flows are potentially evolving in such a way as to keep international analysts glued to the news cycle. The story arguably begins with China’s decision to allow greater currency flexibility, an event that was greeted by the financial press as a sign of China’s economic maturity and a phenomenal win for the US Treasury. But the story just evolves in new and interesting directions. From the Wall Street Journal:

A strong yen is giving Tokyo an awful headache. Beijing is adding to the problem. If things get worse, these old rivals could find themselves facing off in global currency markets.

China has ramped up its stockpiling of yen this year, snapping up $5.3 billion worth of the currency in June, Japan’s Ministry of Finance reported Monday. China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined. That’s making the yen even stronger than it otherwise would be.

Interestingly, to the extent that China makes a minor adjustment to the Dollar peg, authorities simply redirect some of those capital flows to Japan. Note that, arguably, Japan is the least capable of absorbing those flows. Seriously, Japan is the biggest basket case in the industrialized world (although US policymakers are sprinting to keep up). The all too predictable outcome, via Bloomberg:

Japan will pay closer attention to movements in the yen, which have been “a little bit one-sided” after the U.S. Federal Reserve announced a plan to boost the world’s biggest economy, Japanese Finance Minister Yoshihiko Noda said.

“Excessive and disorderly currency moves are harmful for the stability of the economy,” Noda told reporters in Tokyo today. “We will keep a close watch on the market and pay closer attention to it.”

Noda’s comments signal growing concern among politicians about the risk the yen’s climb toward a 15-year high poses to the export-driven recovery. The yen gained against all 16 major counterparts today as investors bought safer assets on speculation the global economic recovery is slowing.

The Fed said yesterday it will maintain its holdings of securities to stop money from draining out of the financial system. Japanese stocks declined, with the benchmark Nikkei 225 Stock Average falling 2.5 percent, after the announcement failed to quell concern a recovery will falter.

And, via Dow Jones:

Japan’s Ministry of Economy, Trade and Industry announced Wednesday it will conduct an emergency survey of approximately 200 companies to assess how the recently strong yen has affected their operations, the Nikkei business daily reported on its online edition Wednesday.

The news comes as the dollar dropped to a 15-year low against the yen Wednesday at Y84.72, a development that is likely to increase concerns among Japanese exporters. A strong yen makes Japanese products more expensive overseas and eats into revenue sent back to Japan.

The trade ministry’s survey will question firms on how the recently strong yen has impacted upon management issues related to exports, as well as sounding out how companies intend to deal with the effects of the strong yen going forward, according to the Nikkei.

And note the global slowdown is weighing on Japan too:

Japan’s machinery orders recovered in June, but growth was weaker than expected, suggesting the strong yen, slowing exports and a murky global economic outlook are making Japanese companies more cautious about expanding.

Will Japanese authorities intervene to keep a lid on the Yen’s appreciation? The consensus among analysts is they will not. Via the New York Times:

Indeed, many analysts do not expect Japan to intervene. To be effective, such intervention requires international coordination; moreover, Tokyo has supported Washington’s efforts to pressure China to let its currency appreciate, as part of a commitment among the world’s largest economies to let market forces determine currency levels.

You see, currency manipulation is considered out of style for everyone but the Chinese authorities. Japan is expected to continue to play ball with the G-20 stance. Even if it makes little economic sense – a good case can be made that the best policy option for at least two nations, the US and Japan, is to easing quantitatively via the purchase of foreign currencies, just not each other’s. (As an aside, I find the obligatory line about the importance of “international coordination” just plain silly. It seems that China has managed to independently manipulate currency values quite effectively).

Now, suppose Japanese officials believe that intervention is required regardless of the G-20. Presumably, they will give US Treasury Secretary Timothy Geithner a phone call to at least keep him in the loop, if not to receive his implicit consent. One wonders if Geithner will recognize what he would be consenting to: Japanese intervention, if it occurs, means that Chinese authorities managed to get Japan to acquire their Dollar reserves for them. Instead of buying Dollars, China buys Yen, which in turn induce Japan to buy Dollars. This maintains the artificial capital flows to the US while allowing China to escape accusations of being a “currency manipulator.”

By the way, how is that Chinese revaluation going? Predictably disappointing. Note this story from Bloomberg:

Chinese policy makers may have extra room to loosen lending curbs and boost investment in coming months after slower growth in retail sales and industrial output signaled ebbing inflation pressures.

July’s 3.3 percent gain in consumer prices, announced by the statistics bureau in Beijing yesterday, may be the peak for the year, according to Nomura Holdings Inc. and Mizuho Securities Asia Ltd.

Industrial production expanded at the weakest pace in 11 months in July, highlighting the moderation in growth triggered by government curbs including a 7.5 trillion yuan ($1.1 trillion) lending limit for 2010. Softening export orders show the risk that weakness in overseas demand will drive a deeper slowdown in the world’s third-biggest economy.

“Policy makers may have more room to sustain growth if needed,” said Sun Chi, a Hong Kong-based economist at Nomura, who previously worked for the U.S. Treasury in Beijing. “The lending quota could be loosened to sustain ongoing investment projects.”

Recall, one of the reasons to allow the renminbi to appreciate was to keep a lid on inflationary pressures. But that rationale will be off the table now that inflation has “peaked” and growth is ebbing. The People’s Bank of China is quick to react:

China’s yuan fell the most in seven weeks on speculation policy makers will counter appreciation amid signs of a slowdown in the world’s third-largest economy.

The People’s Bank of China today lowered its daily reference rate by 0.36 percent to 6.8015 per dollar, the steepest drop since a dollar peg was scrapped in July 2005, after a gauge of the greenback’s strength jumped the most since 2008. Industrial output rose 13.4 percent from a year earlier in July, the smallest gain in 11 months, and bank lending increased by the least since March, reports showed yesterday.

“China’s central bank may be adjusting the pace of appreciation since yesterday’s data wasn’t good,” said Liu Dongliang, a Shenzhen-based analyst at China Merchants Bank Co., the country’s six-largest lender by market value. “It’s also probably due to the dollar’s broader strength.”

Note the reference rate. Remember where we started? Bloomberg remembers:

China loosened controls on the yuan’s exchange rate on June 19, after keeping the exchange rate at about 6.83 per dollar for almost two years. The yuan has since strengthened 0.5 percent.

A whopping half a percent, and apparently no more to come given the deteriorating economic outlook. One wonders, given the exploding US trade deficit, how much longer US officials will tolerate this farce? Have the imbalances already become too deep, too entrenched, that they can be resolved with nothing short of another financial crisis? Increasingly, I fear this is true.

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