China and Japan Currency Deal Not Threat to Dollar Reign

China?s surprise currency deal with Japan does little to chip away at the dollar?s reign as reserve currency, but it could foreshadow an era when the yuan has more global influence.

Getty Images Prime Minister Yoshiko Noda and President Hu Jintao

The two countries announced Sunday that they would start direct trading their currencies, instead of using the dollar as intermediary. The move is part of a financial agreement between the two countries following meetings between Japanese Prime Minister Yoshiko Noda and Chinese President Hu Jintao.

China is Japan?s biggest trade partner with annual two-way trade of close to $350 billion, and as part of the agreement Japan will also apply to buy Chinese bonds next year.

?I don?t think this will be regarded as a defining moment,? said Deutsche Bank [DB? Loading...? ? ? () ? ] chief G-10 currency strategist Alan Ruskin.

?There?s enough bilateral trade to justify a direct conversion from the yuan to yen and yen to yuan. While there?s a wider story there of whether it changes the role of the dollar as a reserve currency, that?s much more questionable. It would be a very, very small step in that direction,? he said.

?While there?s a wider story there of whether it changes the role of the dollar as a reserve currency, that?s much more questionable,?
Alan Ruskin
Chief G-10 Currency Strategist, Deutsche Bank

Ruskin said the move by Japan to buy Chinese bonds may be a bigger part of the story than has been portrayed. ?I don?t think of Japan as being comfortable with the Chinese buying more yen assets as a way of diversifying from the dollar,? he said, adding the Japanese would prefer if they also had access to China?s capital markets.

The so-called Dim Sum bond market is about $30 billion and not very liquid. ?Japan wants market intelligence. It can achieve this by quite modest investments of a couple hundred millions dollars, not billions or tens of billions,? writes Marc Chandler, chief currency strategist at Brown Brothers Harriman.

Chandler said the agreement is not heralding decline for the U.S. ?This seems to be a stretch. Japan is not moving in China?s orbit. They recognize each other as rivals.?

Ruskin said China would have to conduct much more open policy in order to make the yuan more influential, and that is unlikely in the near future. ?If the yuan were to start trading independent of the dollar, that would start to shift currency regimes in Asia away from their dependence on the dollar, including the yen,? he said.

The tight peg between the dollar and Chinese yuan has been a source of friction between Beijing and Washington, which sees the close link as depressing the yuan, a disadvantage to U.S. industry. Chinese officials have said they would like to expand the use of the yuan globally and also would like to see the dollar play a less important role.

?We expect the Chinese currency will be internationalized. We?re a long way away from that? said Ruskin. ?You need free convertibility. You need a capacity to invest in highly liquid markets,? he said.

As for the dollar, "if it?s a chip away, it?s a small chip away. What you?ll find over time is there will be multiple chips away at the dollar?s reign as supreme reserve currency. The dollar is losing maybe one percent per annum,? he said, adding the euro was taking up some of the slack. But with the euro zone?s debt issues, the euro may not be much of an alternative for now.

Meanwhile, German Finance minister Wolfgang Schaeuble commented on the currency deal. ?These are developments which show us that it?s good we have a unified Europe. United, Europe is the strongest economic area in the world. We have good chances to pursue our interests and the opportunity to implement them in the world,? he said.

Follow Patti Domm on Twitter: @pattidomm

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Source: http://www.cnbc.com/id/45797476?__source=RSS*tag*&par=RSS

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