Monday, May 28, 2012

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. Furthermore, the rate will be "set" in China based on market conditions – this won't be a blind two-sided spot market. But that detail is buried in the details of the better news coverage, not in the lede.
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


Anonymous said...

Where to park long term funds of Japanese Pensions that is the question. Clearly buying US Treasury Bills is a no no now. Innovative ways of parking these funds have to be invented. For example spending $500m cutting of the top of a coal mountain within Japan, constructing basic infrastructure, etc - all in readiness to cheaply exploit the reserve twenty years down the road, instead of investing the $500m in US Treasury Bills.

Mike Smitka said...

Ah, but placing a big bet on what the price of something will be 20 years from now is hardly a good option, either. What will coal be worth in 2035? -- since any such plan will take a few years to get started.

But it's not just Japan; long-term real returns are hovering around 0% right now in many economies.

I try not to look at my TIAA-CREF.