TOKYO – The costs of a chronically weak yen just grew by US$18 trillion as China’s economy, Asia’s biggest, may be joining the race to the bottom.
It’s still unclear if the drop in the Chinese exchange rate that began Friday is the start of a trend that would surely rock global markets or just a fluke. But the correlation with the Japanese yen’s decline is hard to ignore.China’s maritime power cause for action and alarm
To be sure, President Xi Jinping’s team threw markets a lifeline on Monday. The People’s Bank of China signaled that the yuan might not be about to plunge with a slightly higher-than-expected daily reference rate of 7.0996 per dollar. That’s the biggest strengthening bias since November.
Even so, many analysts think the PBOC may be finally losing tolerance with Japan allowing the yen exchange rate to drop so far with little blowback in Washington – particularly as China struggles to keep economic growth as close to its 5% target as possible.
Chinese authorities don’t announce weaker-than-expected daily fixing levels in a vacuum. The decision on Friday to fix the yuan rate lower as the yen was sliding anew hardly seems a coincidence.
“After Friday’s fireworks with the PBOC nudging the yuan weaker, markets have run with it,” says Sean Callow, senior currency strategist at Westpac.
Are the beggar-thy-neighbor currency strategies of the past returning to China’s $18 trillion economy?
Economist Brad Setser, senior fellow at the Council on Foreign Relations, speaks for many when he observes that Friday’s hint still “leaves the ‘why now’ question unanswered.”
Only time will tell. Odds are, Xi and Premier Li Qiang would prefer to keep any weakening in the yuan orderly. Unleashing panic in currency circles – and in a US election year – hardly seems in Beijing’s best interest.
Already, presumptive Republican nominee Donald Trump is threatening 60% taxeson all Chinese imports and has even suggested 100% tariffs. US President Joe Biden, meanwhile, might engage in his own race to the bottom in a who can be more anti-China contest on the campaign trail.
Look no further than the overwhelming bipartisan support for banning ByteDance’s TikTok app on national security grounds.
In this context, says economist Robin Brooks at the Brookings Institution, Sino-US trade tensions could be seen as yuan-negative. “You can think of a tariff as a negative” in “terms of a trade shock on a country like China. So, it’s a perfectly rational response for markets to price a stronger US dollar and weaker RMB, in this case. Market behavior is entirely in line with what theory would prescribe.”
Yet the specter of a weaker yuan could be a game-changer on a number of levels. The fallout in Washington could be considerable. Just about the only thing Biden’s Democrats and Republicans loyal to Trump agree on is tightening the screws on China.
The charged conversations at US Treasury Department headquarters alone will be a matter of breathless intrigue among analysts. Treasury Secretary Janet Yellen will be under growing pressure to add Xi’s government to its currency manipulation watchlist.
At the same time, Trump’s threat to revoke China’s “most favored nation” status might leave Biden’s White House feeling compelled to sign on, too. Or to go even further to limit China’s access to semiconductors and other vital technology. Tesla founder Elon Musk, for example, is practically begging for fresh tariffs on China’s electric vehicle (EV) makers to protect his US market.
It would put Treasury officials in a tough spot if they gave Tokyo a pass on currency depreciation, opening the US to charges of selective outrage.
Last week’s landmark Bank of Japan rate shift flopped in unexpected ways. Since March 19, when the BOJ ended its negative yield policy and raised rates to between 0% and 0.1%, the yen weakened 1.4%. It’s both a sign that traders were unimpressed with the BOJ’s modest pivot and that Tokyo seems comfortable with the yen’s recent losses.
Sure, top Japanese officials are warning traders not to test their patience for a weaker yen with the exchange near 2022 intervention levels.
“The current weakening of the yen is not in line with fundamentals and is clearly driven by speculation,” Masato Kanda, vice finance minister for international affairs, told reporters Monday. “We will take appropriate action against excessive fluctuations, without ruling out any options.”
Kanda added that “we are always prepared” to intervene. “We have seen a large fluctuation of 4% in just two weeks in the dollar-yen, a move that isn’t reflecting fundamentals and I find this unusual,” Kanda said.
Strategist Masafumi Yamamoto at Mizuho Securities thinks Kanda’s “dialed up” warning suggests intervention might happen around the 155 level to the dollar. Goldman Sachs strategist Kamakshya Trivedi thinks 155 is a possibility as macroeconomic dynamics weigh on Japan’s economy.
Yet Japan’s soft economic performance suggests Tokyo isn’t as keen to halt the yen’s drop as its official protestations might suggest. At the close of 2023, Asia’s second-biggest economy only narrowly avoided recession.
Japan’s economy contracted 3.3% in the July-September quarter year on year and expanded just 0.4% in the October-December period. Household spending plunged 6.3% in January from a year earlier, the sharpest drop in 35 months.
“The economy isn’t in recession but it’s not far from one,” says Stefan Angrick, an economist at Moody’s Analytics. As such, he adds, “it’s hard to see the BOJ embarking on quick-fire rate hikes from here. Household and business spending are weak and inflation is falling.”
At the moment, indications are that manufacturers have “enjoyed notable and wide-ranging improvement thanks to the weak yen, with particularly marked gains in retail, wholesale, transport and utilities,” notes Masayuki Inui, an economist at Morgan Stanley MUFG.
Risks abound, of course. One is the BOJ upending the so-called yen-carry trade. Two-plus decades of zero rates and quantitative easing made Japan the globe’s top creditor nation. Since the late 1990s/early 2000s, financiers of all stripes – hedge funds, especially – routinely borrowed cheaply in yen and moved that cash into higher-yielding assets everywhere.
As such, sudden yen moves have a knack for shoulder-checking world markets. They often reverberate through stock, bond, commodity and real estate markets from New York to Sao Paulo to London to Mumbai to Seoul.
Given that bourses in Shanghai and Shenzhen lost around $7 trillion of market value from a 2021 peak to January of this year, you would think yen-driven chaos is the last thing Asia wants.
Yet the yen’s trajectory may be giving Xi’s Communist Party geopolitical cover to engineer a more advantageous exchange rate, too. It’s become “more of an option” for the PBOC “as the economy struggles to find its footing,” notes economist Brendan McKenna at Wells Fargo Securities.
Erwan Rambourg, luxury industry analyst at HSBC, notes that the consumer demand situation in China is “proving tough.” At the same time. Beijing has made limited progress toward ending Japan’s property crisis, stabilizing local government financing or addressing record youth unemployment.
Raising China’s financial system, recalibrating growth engines and restoring confidence would be easier in a stable economic environment. These reforms and others were detailed at this month’s National People’s Congress.
As Trivium, a China consultancy, puts it: “This may all sound abstruse, but it’s critically important. Xi is asking officials to rethink fundamental aspects of how the party runs the economy. That opens the door to all sorts of changes with respect to property rights, state ownership and how resources are allocated in society. In other words, this could be big.”
As China’s cracks deepen, many investors worry that Xi’s team might not have the broadband or the audacity to shift growth engines from excess investment and smokestack industries in favor of the private sector. Or the ability to multitask to build the social safety nets needed to increase domestic demand.
Amid intensifying headwinds, no lever might reap bigger or quicker benefits than a weaker yuan. So far, Xi’s men have avoided this option. On the one hand, it might squander progress Xi’s team has made over the last 8-10 years to build trust in the yuan as a reserve currency alternative to the dollar.
On the other, it might give Biden and Trump common cause to intensify Washington’s trade war on the world’s biggest trading nation. A weaker exchange rate also might increase the odds that more giant Chinese property developers default in the months ahead, ala China Evergrande Group.
Asia’s paranoia about a weak yuan dates back to the 1997-98 Asian financial crisis. Back then, devaluations in Thailand, Indonesia and South Korea caused one of modern history’s most dramatic financial domino effects.
The resulting chaos pushed Malaysia and the Philippines to the brink. It also put Japan against the ropes. At the time, officials worried that if Beijing let the yuan drop it would trigger even bigger devaluations in Bangkok, Jakarta, Seoul and beyond.
Twenty-five-plus years later, it’s now a chronically weak yen that might give Xi all the ammunition he needs to pull the exchange rate trigger. With reason, of course. The last thing Beijing would want to be blamed for is catalyzing the next global crisis. Hence the PBOC moving today to signal its support for the status quo with a firmer daily reference rate.
But the longer Tokyo pursues a weak yen policy at a moment of increasing peril for China’s economy, the greater the odds Beijing will follow suit. Expect Beijing’s daily yuan fixing exercise to become an obsession among global investors in the days, weeks and months ahead.
Follow William Pesek on X, formerly Twitter, at @WilliamPesek