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Japanese Yen - Intervention Remains a Risk |
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China's move towards Yuan convertibility is particularly important for Japan and USDJPY. Since the Yuan is not readily available for trading by individual speculators, many traders have opted to express their views through the Japanese yen instead. USDCNY forwards have a very close relationship with USDJPY (as seen in the chart below), which substantiates the usage of USDJPY to express views on the Yuan. In fact, between January 2003 and January 2005, the correlation between 6-month USDCNY forward rates and USDJPY is over 80%. The selection of this pair as a trading alternative stems from Japan's close ties with China. As a net exporter, Japan competes heavily with China. China's artificial suppression of |
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the Yuan has forced Japan to intervene aggressive to artificially depress their own currency throughout 2003 and early 2004. Although Japanese authorities have been absent from the market for the past few months, the market is still cautious as the possibility of government intervention looms, especially considering that the dollar is still hovering at 5 year lows against the yen. The undervaluation of the yuan creates a significant disadvantage for the rest of the G7. The severe negative economic consequences of the undervaluation have forced other G7 countries to pressure China to revalue their currency. |
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Possible Scenarios For USDJPY If A Revaluation Occurs |
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- Scenario 1 - China succumbs to political pressure and floats currency - USD "NEG" JPY "POS"
- Scenario 2 - China widens trading band or pegs to a basket of currencies - USD "NEG" JPY "POS"
- Scenario 3 - China does nothing and keeps currency pegged - JPY rise capped
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Scenario 1 - China succumbs to political pressure and floats currency (Least Likely) |
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Floating the Yuan anytime in the near future is completely improbable. China knows that if they float the Yuan, it will only head in one direction. Speculators will flood into markets, pushing the Yuan to excessive levels. This will threaten their exports, which has been the foundation for the strength of their economy. In fact, a free float is not necessarily in the US' best interest either. China is a large owner of US treasuries. They have accumulated foreign exchange reserves in excess of $350 billion. They are currently the second largest purchasers of US treasuries, next to Japan. Hence, they play a pivotal role in keeping US interest rates low, supporting the US recovery. If China floats their currency, they will no longer need to accumulate foreign exchange reserves at such an aggressive pace. In fact, their demand for US Treasuries will fall significantly, which |
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could lead to a back-up in long-term US interest rates and hence, cause a collapse in the bond market which would jeopardize the US recovery.
In the unlikely event that China announces a free float of their currency, the USD/CNY would collapse, as speculators rush to buy the Renminbi (CNY). This would lead to a one way directional move for the Yuan, which could wreak havoc for the Chinese economy as buying by speculators result in exchange rate overshooting. The USD will also fall significantly, as the market realizes that a revaluation by China increasing the risk of US treasury dumping. The JPY would rise significantly because a floating Renminbi would give Japan the flexibility to allow the JPY to appreciate as a result of increased competitiveness. |
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Scenario 2 - China widens trading band or pegs to a basket of currencies (Most Likely) |
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The most likely scenario is that China will gradually widen the trading band for the Renminbi or to peg the Yuan to a basket of currencies. China has recently taken many measures to move closer to Yuan convertibility or slow the economy, which coincides with the sell-off in USDJPY. They have already increased interest rates, loosened regulations on non-trade related currency transactions for multi-national corporations, and allowed travelers to use Yuan-denominated bank cards for withdrawals in Korea, Thailand and Singapore. The government has also announced that they will actively and steadily push yuan rate reform. Basically, China is gradually easing capital controls as they move towards Yuan convertibility. This gradualness is still yen positive because it would provide Japan with the flexibility of allowing its currency to appreciate as a result of increased competitiveness.
Also, a moderate revaluation will not significantly hurt exports. Foreign corporations have invested billions of dollars in partnering with local firms or building factories in China. A moderate revaluation would not significantly hurt the competitiveness of Chinese exports or threaten the outsourcing advantages that foreign corporations are currently benefiting from, forcing them to move their factories/businesses to countries with |
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more inexpensive labor. China would finally be carrying a bit of the USD depreciation, making this choice the most equitable for everyone.
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If China elects to adjust their trading band marginally, speculators will rush to push USD/CNY down to the bottom ofthe new trading band. Initially, the US dollar will slide as the market realizes that a revaluation implies that China either has to reduce or dump their purchases of the US treasury holdings. The JPY would rise significantly because a stronger Yuan would give Japan the flexibility to allow the JPY to appreciate as a result of increased competitiveness. 100 is deemed to be important level in USDJPY and assumed to be the Bank of Japan's next level of defense. Japan has consistently blam ed China for causing their deflationary problems by forcing domestic prices to remain cheap to compete against Chinese imports. Yuan revaluation should give other Asian central banks leeway to allow their currencies to appreciate. An adjustment of the Yuan's trading band may be the catalyst that USDJPY needs to fall below the 100-level. Until then though, intervention remains a risk that will prevent USDJPY from selling off too excessively. |
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Scenario 3 - China keeps currency pegged (Probable) |
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China is not one to easily succumb to political pressures or be willing to take the blame for a sluggish global economy. As one of the largest economies in the world, it knows that the world is dependent on them for inexpensive exports and that they have significant political advantages as large owners of US treasuries and agencies. If the world economy were thriving, China's rapid growth and rising currency would not be as much of a concern as it is now. It was not too long ago that multinational corporations were harping on the advantages of outsourcing to China. However, with a weak global economy, market share is very precious, therefore corporations are looking for any avenue to increase profits or shift blame. China is reluctant to revalue because they do not want to lose their relative competitiveness and threaten their export-led growth - the crux of China's ability to grow 7-10% per year since 1994 has been their inexpensive labor.
Despite rapid growth, China is still grappling with domestic problems - unemployment remains high, the country is just rising out of deflation and outstanding bank loans are currently in excess of 140% of GDP. Over the past two years, lending has soared 34% with a corresponding increase in nonperforming loans (31.4% of loans |
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in 2002 were non-performing). All four of China's largest banks are technicallyinsolvent. In fact, this is such a grave concernthat the central bank raised its reserve requirements for financial institutions from 6% to 7%. The health of the domestic economy has always been their primary concern. The country's top priority is to maintain internal stability, economic growth and rising employment as the country transforms itself from communism to capitalism. Therefore it would not be surprising if they elected to ignore the world's complaints and focus on internal development.
If China decides to keep their currencies pegged, the rise in the JPY will continue to be capped. The MoF/BoJ will be forced to continue selling JPY in fear that the rise in their currency will threaten their export led recovery. This means that although the natural trend of USDJPY is lower, the path downwards will be choppy. Whether it is overtly or covertly, we expect that the Bank of Japan will continue intervening. The MoF/BoJ may not be very accepting of a move below 105 if China does not budge on their foreign exchange policy. |
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