Tokyo and Beijing Agree on Currency Pact

BEIJING—A wide-ranging currency agreement between China and Japan is expected to give the Chinese yuan a more powerful role in international trade, but Beijing still must make substantial changes in how it manages its economy before the yuan becomes a currency powerhouse on the scale of the dollar or euro.


Economic woes in Europe and U.S. have undermined market confidence in the dollar and euro, but investors looking for a safe place to store their money have few other currency options. China, among other nations, has objected to the primacy of the dollar in international trade, and has suggested other ways to run the international monetary system, including giving a bigger role to the International Monetary Fund and a wider role for the yuan.
Those discussions have largely been theoretical. But during a visit to China by Japanese Prime Minister Yoshihiko Noda, which ended on Monday, China and Japan announced a series of deals that promote the use of the yuan in trade and investment between the world's second- and third-largest economies, which would limit somewhat the use of the dollar in Asia, the world's fastest growing region. Specifically, the two countries agreed to promote direct yuan-yen trade, rather than converting their currencies first to dollars, and also for Japan to hold yuan in its foreign-exchange reserves, which are now largely denominated in dollars.
Japan "seems to be acknowledging implicitly that there will be a single dominant Asian currency in the future and it won't be the yen," said Barry Eichengreen, a University of California at Berkeley economic historian. Harvard University economist Jeffrey Frankel said that "this hastens a multicurrency world, but this is just one of 100 steps along the way."
A Japanese government official said that in the future, Asian currencies "may become more important than they currently are". But Japan hasn't necessarily decided to buy Chinese government debt based on the view that the yuan is likely to become more popular and dominant than the yen. "The yen's role will rather become more important to other countries if we deepen our relationships with them," the official said.
The pact comes at a time when the yuan has faced downward pressure as investors and businesses have lowered their expectations for a continued rise in the currency. The accords suggest that China is looking to speed up its efforts to raise the yuan's profile overseas. That's especially evident in Tokyo's decision to buy up to $10 billion worth of Chinese government debt for its reserves. Though that represents only about 1% of Japan's $1.3 trillion foreign-exchange reserves—the world's second-largest after China— it's important symbolically as a sign that Japan will diversity away from the dollar in the future.

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Associated Press

A bank clerk counts yuan notes in Suining city in China's Sichuan province. A pact with Japan is seen giving the yuan a greater role in trade

Even so, the move is likely to be quietly welcomed by the U.S. government, which has encouraged China to seek a bigger role for the yuan. That's because U.S. government officials realize—as do Chinese reformers—that for the yuan to play a much bigger role, China needs to broadly revamp its financial-sector policies. Morris Goldstein, an economist at the Peterson Institute of International Economics in Washington D.C. said those policies would include sharply reducing its exchange-rate intervention, liberalizing interest rates, reducing restrictions on capital flows and putting its banking system "on a more market-oriented basis," so the yuan can trade freely.
Such policies are likely to put upward pressure on the yuan versus the dollar, which has long been U.S. policy. According to Chinese state television, Japanese officials notified Washington of the agreement ahead of the announcement and reiterated Japan's confidence in the long-term prospects for the dollar. A U.S. Treasury spokesman didn't comment.
The deals with Japan also are in line with the goal of the Group of 20 industrial and developing nations to make the Chinese yuan more flexible.
But the agreements are unlikely to have any significant effect on the yuan's global role anytime soon. Neither China nor Japan has announced any timetable for implementing the plans. Authorities in both countries have agreed to set up a working group to discuss how to put the measures to work.
So far, China has taken some incremental steps toward setting the yuan free. Hong Kong, the only place outside mainland China where the yuan can trade freely, has become the world's fastest-growing currency market in the world.
The new agreements with Japan include measures aimed at making it easier for companies to convert the Chinese and Japanese currencies directly into the other, without requiring an intermediate conversion into dollars, the current common practice. The change should reduce costs for the companies involved. About 60% of all Japan-China trade is currently settled in the dollars.
The package also includes "pilot program" to allow the government-affiliated Japan Bank of International Cooperation to sell yuan-denominated bonds on the mainland market. No detail on the size or timing of any JBIC offering has been disclosed.

JBIC, a lender charged with helping Japanese firms doing business abroad, would be the first foreign-government entity to take such a step, as China's domestic bond market—totaling more than 20.1 trillion yuan in debt outstanding ($3.2 trillion), has largely been off-limits to foreign issuers.
Thus far, the Asian Development Bank and the International Finance Corp., the financing arm of the World Bank, so far have been the only foreign issuers of yuan bonds in China. Neither is affiliated with any foreign government.
Choosing mainland China to issue bonds, rather than Hong Kong, where interest rates on yuan bonds are generally lower, "shows the commitment from the Japanese side to promote the yuan," said Woon Khien Chia, an Asian analysts at the Royal Bank of Scotland.
In recent weeks, Beijing has unveiled a number of steps to promote the use of the yuan overseas, including starting to allow foreign firms to invest yuan accumulated overseas in mainland China.
The People's Bank of China, the country's central bank, has also been using so-called currency swap deals with other central banks so that foreign banks could supply more yuan to their customers. Currently, the PBOC has such deals with a dozen foreign central banks including Thailand, South Korea and New Zealand, totaling 1.2 trillion yuan.
The most significant measure China has taken so far is allowing cross-border trade to be invoiced and paid in its currency. Yuan-settled trade now accounts for about 10% of China's total trade, compared with less than 1% a year ago. Analysts at Deutsche Bank AG predict that yuan-settled trade would amount to 3.7 trillion yuan next year, or 15% of China's total trade.