China-Japan form currency bloc. Is this the New Kid on the block?

Posted on January 9, 2012

In late December the Japanese government announced that Japan and China will advance direct trading of yen and yuan without using U.S. dollars as the base. Further volatility and uncertainty in the worlds’ currency markets, created by the European debt crisis, has encouraged the promotion of a medium that will cut trading costs and will supposedly reduce currency exposure. Approximately 60% of trade transactions between the second and third largest economies in the world are settled in U.S. dollars. China is Japan’s largest trading partner. Given the vast amount of trade volume between China and Japan, this accord has a far greater significance than other pacts that China has agreed to with other nations.  This could be the beginning of the development of an independent market that will challenge the dominance of the dollar.

In addition, China has agreed to allow Japan to apply to purchase Chinese bonds this year. According to the finance minister of Japan, “buying of Chinese bonds would be beneficial for Japan because it would help reveal more information about financial markets in China, the world’s largest holder of foreign currency reserves.”  China, in turn, is already a major investor in Japanese debt. China has also recently approved other countries and central banks eligibility to buy Chinese bonds and other yuan assets. This sizeable alternative investment marketplace could diminish the flow of capital into the U.S. and, in turn, affect the strength and growth of its economy.

And now for the pièce de resistance. While Japan and China have been cultivating their trade treaties and economic agreements, they have also been quarrelling for decades over a group of disputed islands in the East China Sea. This on-going, sometimes quite heated, disagreement, has been the source of severe strain on their political discourse and international diplomacy. However, China and Japan, two unlikely political allies, have established a common cause: North Korea. The new prime minister of Japan recently said that he and his Chinese counterpart had agreed to work together in dealing with North Korea, and promoting stability on the Korean peninsula.  The new prime minister’s first official visit to Beijing would have routinely focused on historically sensitive issues such as the islands claimed by both countries. But with the death of Kim, and the ascension of his son to power, the main subject matter has shifted. Will this new political alliance hold up in the long term, when past confrontations are revisited or new ones acted out? China has a history of utilizing its economic power to punish enemies and allies alike. Economic trading blocs and attractive, comfortable investment markets do not flourish well or long under a cloud of fear and intimidation.

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