Yuan-Yen Direct

Direct trading between the Chinese and Japanese currencies starts Friday, cutting out the dollar as an intermediary. Rates will be posted in Tokyo and Shanghai, with China’s monetary authorities allowing a 3% daily trading band for the yuan against the yen (the dollar gets a mere 1% band).

And so Beijing takes yet another step along the long road to the internationalization of the yuan. How long before the won joins in, a likely next step given the plans for a free trade agreement between China, Japan and South Korea?

There is no particular reason for trade not involving the U.S. to be exposed to the potential volatility of the dollar. Direct currency settlement should increase yuan settlement of China’s imports and exports, as it lessens the currency risk for Japanese and South Korean buyers of goods denominated in yuan. The same idea is behind plans for an agreement between China and its fellow Brics, Brazil, Russia, India and South Africa, to make loans in their own currencies to facilitate trade. The five Brics plus Japan and South Korea account for about 30% of world GDP, compared to 45% for the U.S., the U.K. and the Eurozone.

Greater use of the yuan in trade could eventually grow into full convertibility of the currency. Before then, though, there will need to be a loosening of China’s capital controls and more opening of China’s capital markets. Both represent a greater political challenge than expanding trade finance. Opponents of reform have been able to argue that China’s national interest has been well served by cross-border capital controls and the ring-fencing of the country’s financial system. Only beyond that still distant horizon lies reserve currency status.

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