When the People’s Bank of China (PBOC) makes a statement, it has a significant impact on the markets, even if its message is somewhat unclear.
A few weeks ago, the PBOC hinted at allowing state-owned banks to sell dollars in order to support the yuan. This move helped stabilize the Chinese currency, which had experienced a 5% decline over the past three months.
This action by the PBOC sparked speculation that Japan might follow suit. Indeed, the yen has already strengthened by 4% against the dollar after a previous decline of 9%. Furthermore, the recent weak U.S. inflation report suggests that the Federal Reserve may soon halt its interest rate hikes, thereby adding momentum to this trend.
However, it is important to note that both China and Japan have lower interest rates compared to the United States. The Bank of Japan’s prime rate stands at only 0.1%, while China’s rate is 3.55%, in contrast to the Fed’s rate of 5.25%. Considering this fundamental difference in interest rates, it is unlikely that any currency sales alone will result in a sustained rally against the dollar. Nevertheless, intervention can prevent excessive volatility in the yuan and yen, enabling a more controlled decline rather than a sudden crash.
Edward al-Hussainy, senior currency analyst at Columbia Threadneedle Investments, emphasizes the importance of managing currency movements cautiously. He states that rapid shifts in exchange rates can be detrimental. Intervening in the market can help mitigate disruptive moves.
Both China and Japan have their own motivations for preferring a weaker currency. A devalued currency would support their export-oriented industries, which are crucial for their economies. Moreover, neither country is greatly concerned about the prospect of importing inflation. However, it is worth noting that an excessively weak currency could lead to public dissatisfaction as imported consumer goods become more expensive. Masamichi Adachi, chief Japan economist at UBS, illustrates this point by highlighting the negative response to a significant increase in import prices last year.
Despite these shared considerations, it is important to recognize the distinct differences between China and Japan. China is currently grappling with a lackluster economic recovery following last year’s lockdowns due to the COVID-19 pandemic. To address the significant challenges it faces, such as high youth unemployment, China needs measures to stimulate growth. On the other hand, Japan’s situation presents its own unique circumstances.
Japan’s Economic Momentum
Japan is currently experiencing its strongest economic growth in recent times. The rise in inflation is a positive development, accompanied by increased wages and home prices, which have not been observed for decades. Additionally, foreign investors are showing a great deal of confidence in the Japanese market. Despite tthe depreciation of the yen, the iShares MSCI Japan exchange-traded fund (ticker: EWJ) has recorded a 14% increase so far this year. Conversely, the Chinese equivalent, iShares MSCI China (MCHI), has suffered a 5% loss.
The Bank of Japan’s Role
Investors anticipate the Bank of Japan (BOJ) to make efforts to strengthen the yen at its upcoming meeting on July 28th. One possible course of action is raising its cap on 10-year government bond yields, also known as yield curve control, from 0.5% to potentially 1% per annum. This adjustment is expected to entice domestic investors back into the market as it becomes more appealing compared to hedging costs associated with dollar investments. By doing so, the BOJ hopes to ensure that the yen remains stable, potentially preventing a repeat of last year’s intervention efforts when the government was successful in maintaining a value above 150 to the dollar. Currently, the yen sits around 138 to the dollar.
The Possibility of Interest Rate Increases
According to Ayako Fujita, chief economist at JPMorgan Securities Japan, it is less likely that interest rates will be raised. Over 70% of Japanese mortgages are tied to floating rates, while small businesses borrow at an average rate of less than 1% annually. Fujita explains that policymakers are cautious about disturbing this equilibrium. With inflation gradually settling near 2% and credit offering incredibly low rates, real rates are at their most negative levels ever in Japan. Additionally, with an expansionary fiscal policy in place, the perfect conditions for asset price inflation are present.
Seizing Investment Opportunities in Japan
Given the current circumstances, investors may want to take advantage of the optimistic economic climate in Japan. On the other hand, China still faces unresolved tensions and challenges.