The yen jumped across-the-board on Friday after China's central bank said it would widen the yuan's trading band against the dollar and raise interest rates and reserve requirements to cool red-hot economic growth.
The People's Bank of China's moves come ahead of talks next week in Washington between US Treasury Secretary Henry Paulson and a Chinese delegation led by Vice Premier Wu Li and this weekend's summit of G8 finance ministers in Germany. The yen, often seen as a proxy for the closely-managed yuan, bounced decisively away from record lows against the euro struck earlier this week.
Many analysts say moves by China resulting in accelerated yuan appreciation - and potentially more appreciation in other Asian currencies - often boost the yen because the Japanese unit is the most liquid and heavily traded Asian currency.
"China is doing this to slow down domestic demand and because of concerns about the stock market. It will give the yen some support into next week but aside from the knee-jerk reaction we'll go back to trading patterns we've seen in previous weeks," Calyon head of FX research Mitul Kotecha said. ING head of currency strategy Chris Turner said the moves could spell trouble for Chinese equity markets on Monday.
The yen rallied sharply in February after a tumble in Chinese equity markets sparked global jitters, causing volatility to soar and the yen to rally sharply as investors trimmed exposure to riskier assets. "Dollar/yen looks hugely misaligned and with the prospect of equity weakness Monday, dollar/yen looks vulnerable," Turner said in a note to clients.
By 1150 GMT, the dollar had slid a third of a percent on the day to 120.85 yen, while the euro fell 0.4 percent to 162.90. Sterling was down half a percent on the day against the yen at 238.17 yen.
The euro's fall against the yen dragged down the euro against the dollar to $1.3475. China's Wu Yi will be leading a delegation to Washington for the second round of a "strategic economic dialogue" taking place from May 22 to 24.
Later on Friday, Group of Eight finance ministers meeting are meeting in Potsdam, Germany. US Treasury Secretary Paulson is not attending, however. Market participants suggested that China's moves on Friday were designed to smooth relations with US and other global economic powers who have expressed dissatisfaction with what they say is Beijing's slow pace of exchange rate reform. The under-valued yuan gives China an unfair competitive advantage on world markets and is a major driver of mushrooming global imbalances in trade and investment flows, they allege.