As the first G7 country to purchase Chinese government debt, Japan is gambling that its $10 billion investment will yield greater insight into Chinese currency policy in addition to one benefit already bagged - reduced upward pressure on the yen. How Beijing manages its currency is at the centre of a range of disputes between China and developed economies and a main point of contention between Beijing and Washington, the relationship that will shape the global economy for decades.
Japan's Finance Minister Jun Azumi said on Tuesday that Beijing had approved a deal allowing Tokyo to buy 65 billion yuan of Chinese debt, equivalent to about $10.3 billion. Analysts said the deal was the first of its kind involving a member of the Group of Seven leading economies, giving China the biggest seal of approval so far in the credibility of the yuan as an international currency.
"Cross purchases definitely enhance co-operation. That is critical for peaceful development of Northeast Asia, and here Japan is ahead of other developed countries," said Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong. "Everybody wants to diversify and China has a good fiscal position, so it makes sense to diversify into Chinese assets."
In tightening its financial relationship, Beijing has promised to rein in its purchases of Japanese government bonds (JGB) when the yen is rising. That will be welcomed by Japanese policymakers who have seen a rally in the yen to a record high against the dollar in the past year as a major irritant to recovery from the 2011 earthquake and tsunami and also as an incentive for Japanese companies to move production and jobs offshore.
"It appeases Japanese lawmakers who were worried that China's JGB purchases were driving up the yen," said Douglas Borthwick, managing director of Faros Trading, a foreign exchange advisory and execution firm. "Before, China had an unfair advantage," he said, referring to Beijing purchases of Japanese debt. "This levels the playing field to some extent."
The Japanese purchases of Chinese debt will sterilise the impact of Chinese purchases of Japanese debt on the yuan/yen exchange rate. That's important for Japan given that China is its main trading partner. One benefit that Japan also hopes to gain from its closer financial relationship is a greater understanding of China's thinking on the yuan.
Japan can tell China when and why it is buying its bonds and at the same time prod China to reciprocate when it buys Japan's bonds. The day-to-day transactions and conversations will give Japan a window into Chinese thinking, a Japanese source said. It may be a small window, but it is a bigger one than most other countries have.
"Over time, they will definitely have a better understanding of China's yuan policy," said Li Jie, director at the Reserves Research Institute at the Central University of Finance and Economics in Beijing. Still, the arrangement could also be a double edged sword. On the one hand, Japan could garner valuable insight into Chinese thinking on its currency, giving it some diplomatic firepower in such forums as the G7 or G20.
But on the other hand, the deal opens Japan to criticism that buying Chinese bonds is an endorsement that implies tacit approval of Beijing's controversial management of the yuan's exchange rate through regular intervention. Indeed, the deal highlights a growing distance between the United States and Japan in dealing with China over its currency. Washington is more likely to be adversarial with China in pushing for appreciation of a currency many lawmakers argue is undervalued. Japan is taking a more conciliatory approach.
"The one country that is likely to remain critical of China is the United States, and that is because it's an election year," said Thomas Harr, head of Asian foreign exchange strategy at Standard Chartered in Singapore. "Otherwise, there is a recognition that China's economy is slowing, so there is less pressure on the yuan to appreciate, and Japan is part of that."
Japan has also intervened in currency markets to try to control the yen but has always claimed this resulted from special circumstances. Otherwise, it has supported the G7 stance that markets should be left to set exchange rates. Japan's purchases of Chinese debt are a "stamp of approval" for the yuan that makes it difficult for Japan to criticise China, Kowalczyk said.
In public, Japanese officials are likely to continue with the occasional call for more flexibility in the yuan, but China is Japan's largest trading partner and likely to maintain that position for some time, so it makes more sense for Japan to try to work more closely with China, analysts said.
The summit in December that forged the debt deal, also agreed to increased use of the yuan and yen in bilateral trade. The debt deal allows Japan to bypass Qualified Foreign Institutional Investor (QFII) quotas that serve as the main channel for foreign investment into China's capital markets. Smaller countries like South Korea, Norway and Singapore can buy Chinese bonds through QFII. The United States has often clashed with China over its regular intervention to manage the yuan, saying it gives Chinese exports an unfair advantage.