Yen and renminbi: The big yen and yuan story
Policies being pursued by Japan and China for different reasons are behind the rising yen and the falling renminbi that are having significant effects on financial markets. Christopher O’Dea finds there is more to come
At a glance
• China is trying to become more like a developed-market central bank, while Japan is testing the limits of central bank policy.
• Currencies ultimately reflect underlying growth prospects and resulting yield differentials.
• While the Chinese and Japanese central banks are at different stages of evolution, both are working to manage defensive currencies that attract capital seeking a safe haven.
While the Brexit-induced volatility in the British pound stole the spotlight for much of 2016, the main event in currency markets was taking place in Asia.
On stage there was a drama featuring the apparently unstoppable rise of the Japanese yen and the apparently ongoing depreciation of the Chinese renminbi. Both plotlines had – and will continue to have – substantial effects on financial markets, while also holding significant implications for institutional investment portfolios in coming years.
Both plotlines also seemed to arise from different central bank practices and policies. The Bank of Japan has been the picture of a developed-market central bank at the far frontier of monetary policy, struggling to boost growth through epic liquidity injections and a series of novel tactics such as negative interest rates and the ‘yield curve targeting’ rolled out in late September. But the yen continued to rise despite the use, by the Bank of Japan (BoJ), of increasingly sophisticated policy tools aimed at lowering Japanese interest rates and boosting economic growth.
One time zone west of Tokyo, the People’s Bank of China (PBOC) has been striving this year to develop and implement the mechanisms of modern central banking policy and practice. It is also trying to tackle China’s own structural challenges – namely, the transition to a consumer-led economy and the need to slow the increase in debt in most sectors of the Chinese financial system.
The PBOC has relied on central-banking basics such as window guidance, reference rates and loan quotas to implement policy and manage the value of the renminbi. In the past several months the PBOC has taken to injecting liquidity directly, instead of cutting reference rates, in an effort to develop an interest-rate lever similar to most developed-market central banks.
It is one of several areas Chinese officials are modernising to prepare the country’s financial system for what currency investment managers say is the inevitable – the full convertibility of the renminbi, which would place the currency on par with the yen and the freely-floating currencies of major developed countries. While China needs to build the apparatus that will be needed to manage Chinese interest rates when the renminbi becomes convertible, currency managers say it is important for investors to recognise that the renminbi is likely to behave much like the yen once it gains full membership in the global financial system.
“The RMB is going to be under a defensive currency heading,” says Mark Farrington, portfolio manager and head of macro currency group, part of Principal Global Investors, which manages $2.2bn (€2bn) in active currency strategies for institutions. Both Japan and China have high domestic savings rates and run current account surpluses, which are primary characteristics of a currency that will attract investors seeking to preserve value, he says. “This suggests the RMB will trade very much as the yen did when it became a global currency.”
Currency market volatility in the past year has obscured underlying long-term trends. The renminbi weakened during 2015 owing to hefty capital outflows, forcing the PBOC to intervene to support the currency. “The RMB depreciated approximately 6% against the US dollar in 2016, after an appreciation trend from 2007 to 2014 against the dollar that was almost uninterrupted,” says Javier Carominas, portfolio manager at Record Currency Management, which manages about £40bn (€46bn) in currency exposures for both public and private sector pension funds and other institutional investor groups.
The weakening was not a trend change, but rather “a course correction from the previous strong appreciation trend we’d seen in the RMB”, Carominas says. And that’s likely to continue “as long as the growth differential between the US and China remains”, he adds. He points to the Balassa-Samuelson effect, which suggests that an increase in the productivity of the tradable goods sector of an emerging economy will spur wage growth and higher real exchange rates. “Let’s not forget that currency strength over time is related to per capita productivity,” Carominas says.
Investors can capture the differential between US and Chinese growth prospects by using currencies to lock in the spread between interest rates on dollar and RMB assets, Carominas says. In late September, US Libor stood at 0.8% and the three-month offshore renminbi carried an implied yield of 4%, he says, an attractive 3.2% yield in a world of negative policy rates. “The moral of the story,” he adds, “is that probably the only way to legitimately capture the growth story and the yield differential is through the currency.”
While the renminbi’s long-term appreciation trend reflects a growing economy, the situation is quite different for the yen. Although the yen’s strength stems in large part from its status as a safe-haven currency, the yen now presents considerable policy risk, says Farrington. “There isn’t a consistent positioning on the yen in our portfolio,” he adds.
Those policy risks highlight the gulf between the yen and the renminbi, and the different challenges facing the BoJ and PBOC when it comes to monetary policy-setting and implementation. While the PBOC is working to bring the reminbi into the global financial system, the BoJ continues to push the frontier of central banking.
In late September, the BoJ announced another in a series of monetary policy changes, making an abrupt shift to a “yield curve” approach that will involve the Japanese central bank seeking to maintain certain interest rates on government bonds in to achieve its goal of 2% annual inflation – a goal the bank has failed to attain despite massive monetary injections to spur economic growth.
The BoJ’s stimulus efforts to date were partly intended to slow the yen’s rise, which reduced the competitiveness of Japanese goods and dampened economic growth. But the bank’s purchases of Japanese government bonds (JGBs) under the stimulus policy attracted global investors seeking a safe, if low-yielding, place to park capital. The capital inflows instead pushed the value of the yen steadily higher.
“The RMB will trade very much as the yen did when it became a global currency” Mark Farrington
Japanese analysts expect the new policy regime, called Qualitative and Quantitative Monetary Easing with Yield Curve Control, will result in further appreciation of the yen. Although the BoJ did not lower its official policy rate – already negative 0.1% – the new plan “indicates that the Bank has clearly moved its monetary easing focus from ‘quantity’ to ‘interest rates’”, according to an assessment of the new policy provided to IPE by Sumitomo Mitsui Trust Bank in Tokyo.
According to the BoJ’s own statement: “the Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent).” It goes on to say the BoJ will continue to purchase JGBs “more or less in line with the current annual pace of ¥80trn” and adds “but the guideline for average remaining maturity of the Bank’s JGB purchases will be abolished”.
In announcing the new policy, the BoJ “alluded to future easing methods”, Sumitomo says. These include fixed-rate purchase operations, outright purchases of JGBs with yields designated by the BoJ, and fixed-rate funds-supplying operations for a period of up to 10 years, an extension from one year at present, Sumitomo says.
“One must question whether the Bank of Japan can control the yield curve over a prolonged period,” says Sumitomo. “Setting the 10-year JGB yield at 0% provides an opportunity for speculators.” While it will take some time to see how the new policies impact financial markets, the effect on the currency seems clear, Sumitomo says, “we must now brace ourselves for a stronger yen”.
Volatility in Japanese financial assets is likely to increase in the short term as the nuances of the BoJ’s new tools become clear, Sumitomo says. For global investors, China’s more straightforward currency story may be the preferred focus. Sovereign investors and currency managers have already established accounts to deal directly in renminbi bonds in both the offshore market and the onshore domestic renminbi market controlled by the PBOC, and it is only a matter of time before renminbi-denominated bonds are added to global bond benchmarks, he says. “Over the next three to five years, the world will be accumulating RMB bonds,” he says.