Direct Yen-Yuan Currency Trading

...what is surprising is that it took so long...

Various blogs in the US made a big deal of announcement of a deal to launch bilateral currency trading between the Chinese yuan (officially, Renminbi RMB) and Japanese yen. One strand views this as a harbinger of American decline. The claim is that this is a the beginning of the end of the US dollar as a reserve currency, which will make financing our deficits impossible and produce hyperinflation. One example is Tyler Durden, who posted versions of this on his own web site and at Zero Hedge.

This claim is most puzzling. First, direct trading between currencies is the norm whenever there are enough transactions to make setting up trading desks (more than one on each side) and establishing back office clearing procedures viable. In the case of Japan you can trade directly for the currencies of some countries – the US, Korea, the Euro zone – but heretofore not with its largest trading partner, which for both imports and exports is China. The reason however is the presence of capital controls on the Chinese side, reflecting the lack of liquidity (and experience) in Chinese domestic capital markets.* After all, in 1982 China had no modern banks, and they still lack human capital and institutional know-how. Chinese banks don't yet know how to lend to even medium-sized companies. Instead smaller firms must turn to illegal "curb markets" and extended family for outside financing. So the driver of this shift is not a distrust of the US dollar, but the relaxation of capital controls on the Chinese side.

Second, trading currencies has little to do with reserve currencies. While banks or other brokers do trade for their own accounts, they don't keep open positions long. As one trader phrased it to me, in macroeconomics the long run is a decade; at a trading desk, it's 10 minutes. So while there are capital requirements for brokers to play in the market, and clearing is not instantaneous, this has no impact on the Fed Funds market, much less bond markets.

To sum, the name of the game is transaction costs, not reserve currencies. Firms wanting to buy or sell yuan for yen will still compare direct quotes with cross-trades; the market for yuan-dollar and dollar-yen will remain much deeper than that for direct yen-yuan trades for years to come. That's true even for the Euro: according to the latest BIS statistics, direct yen-Euro trades in 2010 amounted to $111 billion, but Euro-dollar and yen-dollar trading came to $1,101 billion and 568 billion, respectively.** When you trade, you request bid-ask quotes while checking your computer screen and other brokers; you don't even tip your hand by stating whether you're buying or selling.

Conceivably at some point the dollar will lose its reserve status; empires don't last forever. However, it takes more than imperial decline, it takes both financial drivers and the presence of a viable alternative. Even in the 19th century multiple exchange rate systems persisted – Japan was on a silver standard, for example, until it received the Chinese indemnity from the 1895 Sino-Japanese War, which was paid in London, drawable in gold; see the wonderful book by Mark Metzler, Lever of Empire. More generally, there were regional "reserve" currencies, Istanbul for the Ottoman Empire and so on (a project I supervised at W&L on shifts in reserve currency regimes by Palmer Sherer). Now the US empire may be in decline, but it has yet to collapse.

And there's no alternative ready to take the dollar's place. Japan's domestic capital markets are too small for the yen to play that role; hopes for it to serve as a regional currency are hampered by years of zero nominal returns on overnight money. Japan's economy may be growing, but in the eyes of the world it is no longer in ascendance. China's domestic capital markets are even smaller, thin and riven with favoritism. No way any multinational will park next weeks payroll in Shanghai. Anyone want to be on the Euro? – sadly, it's not an alternative, either. So we're stuck with the dollar, and with US monetary policy spilling over to affect the rest of the world.

Note: Chinese capital controls are easy to see, literally: compare the 5-day trade chart at Yahoo! Finance for the yuan (RMB renminbi) and the Japanese yen.

Note: See Table D-8 of the BIS spreadsheet of results of their 2010 survey. The yen also trades in substantial volume against the Australian dollar.

Mike Smitka

Recent GPD and Investment

...the data is in the details, ur, the devil is in the data...

Here are a couple graphs tied to an ongoing discussion on the SSJ (University of Tokyo Institute of Social Science) email forum.

...Mike Smitka...

Reflections on 3/11, the Tohoku Earthquake on year on

...even a disaster of this magnitude has only a transitory impact on a large, diversified economy...

...the collateral damage Japan suffered from the US financial crisis was about four times the size the economic damage it suffered from the earthquake...

Here I am on the Japanese economy on the Canadian Business News Network.

• Part I
• Me ==> Part II <==
• Part III

Mike Smitka

...without nuclear power it will be a long, hot summer throughout Japan...indeed [not a point I made on the show] deaths in this summer's heat waves will surpass those stemming directly from the Fukushima power plant disaster...

3/11 Video

Here is a short, visually nifty video reflecting on 3/11, the Tohoku earthquake, tsunami and consequent secondary Fukushima tragedy. The link should work, the original is at the following URL [click to view]: http://www.onlineschools.org/japan-one-year-later/

Deleveraging in Japan

The System of National Accounts Yearbook for FY2010 is now out; Japanese GDP data unfortunately are not available very promptly and many subaccounts are only available on an annual basis. Anyway, long-standing frustrations aside, the data highlight first the tendency of the economy towards an excess of private savings since 1970. Tracing the outworkings of that provides one way to organize what has happened in the macroeconomy over the past 40 years, with the growth of both current account surpluses and government deficits, in the context of two bubbles, in the 1972-3 period and in the era ended abruptly in 1991.

More sobering from today's standpoint in the US and the EU is the magnitude and duration of deleveraging. Unlike in the US, the late 1980s bubble was driven by corporate borrowing; households were for example net sellers of real estate, particularly land. And so it's corporate deleveraging to which we need to look; that's gone on for 15 years. In the US, the household sector is central, and I don't think the story will be as bad, helped by generational dynamics, foreclosures and population growth. I won't try to model such here. Just look at the graph...data for 1955-2010, splicing together discontinuities due to the shift from SNA68 to SNA93.

Japan's Economic Earthquakes

See the post of 27 July on the Tohoku earthquake and the auto industry at the Autos and Economics blog It focuses on the Japanese economy, but I decided to put in a link rather than paste the article here in its entirety.

Earthquakes, tsunami and nuclear power: behavioral economics

The following are quick reactions, not tight argumentation.

At a forum on the earthquake today at Washington and Lee I was surprised by the interest in nuclear issues as opposed to the quake and its direct impact on people and the economy. So far no one has been hospitalized for radiation exposure; outside the plant levels remain below those that cause significant public health concerns as long as they are not permanent. And there's no sign of a Chernobyl type incident that would poison large swaths of the archipelago. The inside of the plant may be a different story, but since the reactors will never be restarted that's not a substantive issue. In the end, the most likely scenario is thus that no one will be made ill by the reactor problems. Ever. Nor will there be long-standing economic repercussions. And that is ironic if we think of the routine but small-scale disasters that accompany coal mining (most well out of view of video cameras) and the known impact of particulate matter and acid rain, or even the rarer but still frequent level of industrial accidents in petroleum extraction -- and then there's carbon footprint. Nuclear power does not make sense from a financial perspective; it is not cheap power. But it is safer and does make environmental sense compared to the alternatives.

Meanwhile people in the earthquake zone continue to die because of exposure, malnutrition and lack of access to needed healthcare. Virtually all (if not all) of these deaths are of the elderly, particularly those with chronic health issues. But they are far from zero. In addition, people will die because of the rolling power blackouts, due to an increase in accidents and delays in emergency services (which would be an issue even if none of Japan's plants were nuclear ones).

Even stranger, this nuclear issue seems to have drowned out the unfolding tale of roads being made passable, power lines reconnected and food being delivered. That causes no fear reaction, and so leads to none adrenalin rush that can come from sound-and-sight bites on the news. Yet the story has drama, particularly as any single scene is being replicated across a wide swath of Japan.

It even seems to have drowned out the story of 22,000 dead and missing, a number that surely will rise to over 30,000. It saddens me that people are forgetting that in their fascination over nuclear plants.

We cannot build human society trying to protect ourselves from every conceivable disaster. Earthquakes of M9 near densely settled populations are one such; it may be a generation before there is a recurrence, and tens of generations before there is a recurrence in Japan. But M7 earthquakes (1/60th the size of the Tohoku quake) are not so infrequent, and if they occur near an urban center (as did the 1995 Kobe earthquake of M6.9) are horrific enough.

They are a threat worth evaluating. Furthermore, we know how to build so as to mitigate the impact (including any associated tsunami) of earthquakes of M8 and below. Japan has done that. We need to recognize that the shake-resistant construction, the ocean-side seawalls and sirens, the emergency drills, and the disaster response infrastructure all saved untold lives. Indeed, in a "normal" earthquake disaster Japan would have seen neither a major loss of life nor even a long-lasting economic disruption to the affected region. Unfortunately the areas of the US similarly at risk – the west coast in general and California in particular; the Mississippi valley south of St. Louis; and Charleston SC – are ill-prepared. The demand for an adrenalin rush from the nightly news makes that response less likely.