Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

China and Japan: Risk of Currency War

Over the last few months, the risks of such a currency war between China and Japan have increased substantially as pressing domestic economic problems in both countries could tempt them down this path.

In Japan, Abe came to power with a promise to revive the economy through drastic means. Though Abenomics has three “arrows”, the only arrow that is at all effective now is the monetary arrow that has worked by depreciating the yen. The risk is that Japan would seek to rely more and more on this arrow and try to push the yen down to 110 or even 120 against the US dollar. It is even possible that such a strategy might finally revive the Japanese economy.

China also faces a similar temptation. House of Debt has a fantastic blog post showing that since 2008, China has been forced to rely more and more on debt to keep its economy growing because its earlier strategy of export led growth is not working any more. The second graph in their blog post drives this point home very forcefully. Unfortunately, the debt led model is increasingly unsustainable. This month, China witnessed the first onshore corporate bond default. Earlier, a default on a popular wealth management product was avoided only by a bailout.

China’s leaders must now be sorely tempted to depreciate the currency to maintain economic growth without further exacerbating the country’s internal debt problem. Many observers believe that after many years of high inflation and gradual appreciation, the Chinese Renminbi is overvalued today. That would be another reason to attempt a weakening of the currency.

The high degree of intra-Asian economic integration means that a depreciation by either Asian giant would drive down many other Asian currencies (for example, the Korean Won) and make it difficult for the other Asian giant to refrain from depreciating its currency. A vicious cycle of competitive devaluations could rapidly become a currency war. And the already strained political relations between the two countries would clearly not help.

The yen and the yuan are in some ways like the yin and yang of Asian currency markets. A “beggar thy neighbour” currency war between Japan and China would of course have a dramatic impact on the whole of Asia.

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