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By Kosuke Takahashi

TOKYO – Japan and China started direct trading of their currencies, the yen and the yuan, on the inter-bank foreign exchange markets in Tokyo and Shanghai on Friday in an apparent bid to strengthen bilateral trade and investment between the world’s second- and third-largest economies.

Direct yen-yuan trades also aim to hedge the risk of the dollar’s fall in the long run as the world’s key settlement currency and as the main reserve currency in Asia, the world’s economic growth center in the 21st century. By skipping the dollar in transactions, the region’s two biggest economies intend to reduce their dependence on dollar risk and US monetary authorities’ influence on the Asian economy – aiding China’s goal of undercutting US influence in the region.

It is the first time that China has allowed a major currency other than the dollar to directly trade with the yuan. For Beijing, this new step brings benefits of further internationalization of the yuan. For Tokyo, the possible future correction of China’s still artificially undervalued yuan may bring the plus of a weaker yen, boosting profits of Japanese exporters such as Toyota and Sony in the long run.

Japan’s three megabanks – Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group – will begin direct yen-yuan trades with major Chinese banks on Friday. Exchange rates between the yen and the yuan will be determined by their transactions, delinking the current “cross rate” system in which the US dollar intermediates in setting yen-yuan rates.

“We can lower transaction costs and reduce settlement risks at financial institutions as well as making both nations’ currencies more useful and energizing the Tokyo market,” Japan’s Finance Minister Jun Azumi said on May 29.

China welcomed the new trading agreement with much fanfare.

“This will help lower currency conversion costs for economic entities, facilitate the use of RMB [the renminbi, as the Chinese currency is also referred to] and Japanese yen in bilateral trade and investment, promote financial cooperation and enhance economic and financial ties between the two countries,” the People’s Bank of China (central bank) said in a statement.

Skipping the dollar
Up until Friday, Japanese and Chinese firms had paid currency conversion fees twice. For Japanese companies, they first had to convert the yen into the dollar, then they exchanged the dollar for the Chinese currency. For Chinese firms, it was vice versa. With this removal of the interim step by skipping the dollar in transactions, many expect cost reductions.

Japan ranks fourth among China’s trading partners after the European Union, the United States and the 10-country Association of Southeast Asian Nations (ASEAN), while China has been Japan’s largest trading partner for the past three years.

Bilateral trade rose 14.3% year-on-year to reach US$344.9 billion in 2011. For Japan, China accounts for about 20% of its world trade value. Around 50% to 60% of that is being settled in dollars, with less than 1% of it settled in yuan. One Chinese news outlet has estimated direct yen-yuan transactions will realize $3 billion in cost savings.

There are still cautious views on the scale of cost reductions among Japanese market participants.

“Dollar-yen transaction costs are already very low,” Daisuke Karakama, market economist at Mizuho Corporate Bank in Tokyo, said on Thursday. “The cost reduction effect of direct yen-yuan trading should be limited.”

Internationalization of the yuan
For China, this new trading is a step in its moves to internationalize the yuan, accelerating the currency’s wider use. More than 9% of China’s total trade was settled in yuan last year, up from only 0.7% in 2010, according to Xinhuanet.

Yuan-denominated trade between the mainland China and Hong Kong started in July 2009, as Beijing allowed companies in Shanghai and four cities in the southern province of Guangdong to use yuan in trade with Hong Kong, Macau and members of ASEAN. [1] In July 2010, China also allowed the yuan to be more freely traded and transferred in Hong Kong, establishing an offshore yuan market for the first time.

But many experts such as Mizuho’s Karakama believe China will soon face a trilemma in its economic policy.

An economy cannot combine at the same time a non-floating dollar peg currency, free capital mobility and autonomy in its monetary policy. Developed nations such as Japan and South Korea abandoned a dollar peg system in order to secure international inflows of money and discretionary monetary policies. (In contrast, countries using the euro abandoned individual monetary policy by consolidating their financial policy instruments to the European Central Bank.)

In April, the People’s Bank of China announced it would widen the yuan’s daily trading limit against the dollar to 1% from 0.5%.

“With the internationalization of the yuan, it will become more and more difficult for China to control the yuan,” Karakama said.

Should China shift to a limited floating exchange rate system, the yuan will likely appreciate against major currencies such as the dollar. With Japan’s business with China expanding and the presence of the yuan increasing in Japan’s international trade, this will push down the yen’s effective exchange rate against major currencies. Annual trade between China and Japan more than doubled in the past 10 years.

Kosuke Takahashi is a Tokyo-based Japanese journalist. His twitter is @TakahashiKosuke

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