Japan’s And China’s Falling Currencies Should Raise Concerns For Asian Markets

The Japanese yen and Chinese yuan are as different as chalk and cheese. The yen is free floating and the yuan is rigidly controlled. But as the dollar strengthens in Asia due to the U.S. Federal Reserve’s tightening policy, the central banks in Tokyo and Beijing find themselves on the same course of keeping their monetary policies loose.

For very different macroeconomic reasons, the Bank of Japan and the People’s Bank of China have loosened the reins and seem content to see their currencies substantially weaken against the dollar. But the lax monetary policies of the region’s two biggest economies will be a concern for the rest of Asia, which have been raising interest rates due to capital outflows and the dollar’s rise. A weakening yuan, in particular, has the ability to blunt the export competitiveness of rivals, potentially triggering a wave of competitive devaluations.

The Japanese yen is, of course, the poster child for monetary profligacy. Since 2013, the Bank of Japan, under the stewardship of Governor Haruhiko Kuroda, has bravely attempted to arrest a long slump in consumer prices by flooding the financial system with an estimated $5 trillion in easy money, larger than the GDP of the country. The proximate objective of this easy policy was to influence consumer and corporate behavior, attuned to two decades of deflation and to push inflation above the BoJ’s baseline 2 % range.

“It’s desirable for inflation to stably achieve our 2% target accompanied by wage rises,” Kuroda said on October 24. At the same time, the BoJ has been watching closely as the yen plunged to a historic low of 150 against the dollar and has confused markets by intervening in foreign exchange markets to arrest the slide.

South Korea and Taiwan, two of Japan’s immediate neighbors, are bearing the brunt of the BoJ’s bold experiments in influencing price behavior. This is because the troika produce and export high-end electronics and automobiles, so a weak yen provides Japanese manufactures with a significant price advantage. The Korean won, to be sure, has also weakened against the dollar this year (by an estimated 15% compared with the yen’s 20% decline). The risk for regional economic stability stems from the Bank of Korea embracing the doctrine of a weaker won, under pressure from Korean exporters.

These risks get magnified when China and a weak yuan enter the conversation. While Japan is deeply integrated into Asian manufacturing, the supply chains tend to be bilateral in nature. Southeast Asian manufacturers don’t tend to compete with Japanese firms in the global marketplace. But this is simply not the case with China, which is deeply embedded into regional supply chains as the final assembly point for products destined for world markets.

Much of the components are sourced from the region and China is simultaneously a competitor with the rest of Asia on other products and services. While the yuan’s weakness is more measured compared with the yen’s tumble, it has the potential of destabilizing regional stability if the PBOC allows the currency depreciate further.

Chinese policymakers are worried about a slowing economy, with the IMF projecting GDP growth this year at only 3.2 %, a historic low in several decades. Slowing growth can mainly be attributed to suffocating Covid restrictions, but with President Xi Jinping having already secured a third-term in office, Chinese officials might be tempted to loosen conditions even further.

In previous destabilizing economic episodes, 1998 and 2008 come to mind, China has projected itself as a regional leader by not depreciating the renminbi. The rest of Asia will expect the PBOC’s magnanimity to remain in place. However, there is no regional forum where Asian central bankers could sit across the table and discuss cross-border impacts of monetary policy. In theory at least, central bankers will say that such forums exist, but difficult topics are seldom raised.

To be fair to the PBOC and the BoJ, the Federal Reserve is not beholden to the global implications of its policies, which is already having a negative impact on emerging markets across the world. In Asia’s case, it is feeling the impact of second-round effects of U.S. monetary policy via lax policies in two systemically important countries. China and Japan should demonstrate regional leadership by arresting the decline in their currencies and promote regional economic stability. If they fail, a regional currency war will almost certainly be the result.