Commentary Type

The Yen Beckons China's Dollars

Op-ed in the Financial Times


China reportedly wants to diversify large portions of its one thousand billion dollars of foreign exchange reserves out of dollars, where most of them are now held. It is otherwise likely to sustain one of the largest capital losses in history, in terms of both its own currency, the renminbi, and external monies such as the euro, as the dollar inevitably falls by 20 percent or more against virtually all currencies over the next few years to help correct the unsustainable current account deficits of the United States.

The main issue for China is the choice of currencies into which it will shift. The only candidates for large movements are the euro and perhaps a couple of other European currencies, and the yen, in light of the limited size of financial markets elsewhere. Judicious Chinese selection among these alternatives could promote several basic international monetary objectives as well as preserve China's national capital for future financial and developmental purposes.

Diversification into European currencies would be a mistake from both a Chinese and systemic standpoint. The euro and other European monies may still be modestly undervalued against the dollar but most of their needed rise against it has already taken place over the past five years. Hence a Chinese shift from dollars to euros would have little systemic benefit and would not produce much capital gain to China.

By contrast, Chinese diversification of several hundred billion dollars into yen would promote both systemic and Chinese national interests. It is almost universally agreed, including in Japan, that the yen is substantially undervalued against all currencies, except the renminbi itself and perhaps a few other Asian monies, even after its recent modest rise. Adjusted for inflation, the yen is weaker today than in 1998, when the United States and Japan intervened jointly to reverse its precipitous decline, and in 1985, when the Plaza Agreement initiated intervention by the Group of Five leading industrial countries to weaken the dollar, especially against the yen.

This yen weakness persists despite the five-year recovery of the Japanese economy and the country's record current account surpluses that are exceeded globally only by China's. Japanese officials have not manipulated the yen since their massive interventions ended three years ago but it is the persisting misalignment, rather than its cause, that matters and needs urgent correction.

Chinese purchases of yen with a significant portion of their dollar hoard, by strengthening the yen against the dollar in an orderly manner over a sustained period, would thus help correct one of the most important currency misalignments now contributing to the global imbalances. As the markets become aware of such official action, they would probably magnify the extent of yen appreciation and thus promote the needed realignment. This particular form of diversification would probably minimize the inevitable capital losses that China will experience in renminbi terms because the yen is one of the few currencies that needs to rise in value almost as much as the renminbi itself.

China has never formally consulted the United States about its massive purchases of dollars and would be under no obligation to consult Japan as it shifted into yen. The political tensions between the two countries have not precluded their cooperation on monetary matters, however, including participation in the Asia-wide network of bilateral swap agreements (the Chiang Mai Initiative) and nascent steps toward an Asian Monetary Facility. Hence China might want to discuss its plans with Japan and even suggest complementing its own diversification with a shift of some of Japan's similarly large dollar balances into renminbi assets, promoting the needed adjustment of its own currency. China and Japan have already negotiated a bilateral swap agreement and could augment it by implementing their currency cross-holdings via market operations in order to achieve the desired impact on both exchange rates.

There are of course other ways to achieve the desired rise of the yen. Japan could simply sell dollars for yen from its own reserves. The US authorities could buy yen, probably in cooperation with their Japanese counterparts, as they did in 1985 and 1998 (and many other occasions). The Group of Seven could replicate the Plaza Agreement, presumably with respect to the renminbi and other undervalued Asian currencies as well as the yen. But Chinese diversification into yen would serve multiple purposes and would certainly be viewed as a natural monetary operation.

Such Chinese diversification would not solve the fundamental problem concerning the renminbi. China should promptly let its currency rise to a level that would no longer require intervention. This would both reduce its external surpluses, countering the growing protectionist backlash against Chinese exports, and halt its wasteful reserve build-up. But the one thousand billion dollar legacy from the past would still have to be managed and China could refurbish its image as a responsible leader in the world economy by doing so in a manner that constructively promoted global adjustment and stability.

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