China’s trilemma on economy is Japan’s dilemma
Japan has concerns about China’s recent decision to allow the yuan to weaken but as Beijing grapples with what economists call the “trilemma,” trying to balance capital flows, a stable exchange rate and appropriate monetary policy settings, something had to give.
For the moment, Beijing has opted to allow the yuan to take more of the strain and that has left Japan on the horns of a Chinese trilemma.
Japan is clearly uncomfortable with the recent managed depreciation of China’s currency that has seen the yuan fall in value against the yen.
"Japan would face a tough decision on how to respond if China intervenes frequently in the market," said Japanese Finance Minister Taro Aso on August 20, warning Japan was wary of any attempts by Beijing to weaken the yuan so as to give Chinese exports a competitive advantage.
Japan will also be very conscious that other currencies in Asia have also weakened versus the yen.
Yet in recent years, with no capital controls, Japan’s own ultra-accommodative monetary policy provided the backdrop for a very substantial fall in the value of the yen in the international currency markets, depreciation far beyond that already seen, or indeed currently envisaged by most market participants, for the yuan.
As yen flowed out of Japan, seeking better returns elsewhere, a lot of Japanese capital found its way into China.
Now that Beijing’s policymakers themselves seek to utilise easier monetary policy as part of their toolkit in managing the slow-down in the pace of China’s economic expansion, the flows are reversing.
With Beijing having partially liberalised capital controls in line with international requests, looser Chinese monetary policy has recently translated into yuan selling as capital invested in China has sought to exit a bet that no longer seemed quite as attractive.
Seeking to balance the trilemma and keep the yuan stable, the People’s Bank of China (PBOC) leant against yuan weakness, buying the Chinese currency for dollars, thereby eating into China’s vast foreign exchange reserves.
But by buying yuan, and so taking it out of circulation, the PBOC was effectively tightening monetary policy at a time when its objective was to keep it loose.
If, on the other hand, China wished to further ease monetary policy by cutting the banks’ reserve requirement ratio (RRR), it could, at least partly, fund a return of yuan to China’s financial sector, an effective reduction in the liability side of the PBOC’s balance sheet, by selling off foreign reserves from the asset side of the ledger.
Eroding the foreign reserves pool in pursuance of an RRR cut seems far more attuned to China’s current monetary policy objectives. At any rate China’s current economic situation, its monetary policy settings and with it now permitting some degree of yuan weakness, as capital exits the Chinese market, some of it is heading home to Tokyo.
At the same time, analysts are already pondering if yuan weakness, which could mean China effectively exporting disinflation to the United States through cheaper Chinese exports, might yet influence the Federal Reserve and push back the timing of any US rate hike.
Whether that possibility should guide the Fed is an arguable point but two points are incontestable.
The first is that, like the Japanese yen, the US dollar is a beneficiary of capital flowing out from China as US investors bring money home. As those dollars are then moved into US Treasuries (USTs), if only temporarily, the price of that paper rises and, by definition, the yield falls.
Secondly, if the market thinks China’s moves will lead the Fed to hold off, then the attractiveness of current US Treasury yields rises, leading to higher prices as investors buy the bonds and, again, results in lower returns.
In both cases, as the UST interest return falls, the yield differential between Japan and the United States, which favours holding US paper over Japanese government bonds, shrinks, making the argument for the investment less compelling.
In that light, as Japanese investors review their US exposures, some will decide to exit, adding to the yen’s strength versus the dollar as funds are repatriated to Japan, thus eating into Japan’s export competitiveness.
Yuan weakness thus metamorphoses into broader yen strength.
Even so, Japan had no qualms about the impact of currency weakness on others when their own monetary policy settings led to a devaluation of the yen.
Japan has concerns about yuan weakness but few grounds for complaint.