Currency Agreement Signals Baby Steps

Japan and China announced a package of financial agreements during new Japanese Prime Minister Yoshihiko Noda’s visit to Beijing late last week, pacts that will ultimately give the yuan a greater role as an international currency provided that Beijing implements necessary reforms to its financial system. From The Wall Street Journal:

The moves come as China has expressed ambitions about seeking a bigger role for its currency in global markets, especially with investor doubts mounting about the future of the fragile euro, and worries about the steadily weakening dollar. The package of measures—reached by Chinese Premier Wen Jiabao and Japanese Prime Minister Yoshihiko Noda, who arrived earlier in the day in Beijing—will help further that cause.

But the agreements are unlikely to have any immediate significant effect, and, for now, may be mainly symbolic. The governments didn’t announce any timetable for implementing the plans. And as long as China maintains strict controls on the convertibility of its currency, and investments in its economy, there are limits on how much further the yuan can expand internationally.

Still, the accords were striking, given recent tensions between China and Japan, including a prolonged diplomatic standoff just over a year ago in a territorial dispute, and hawkish comments by Mr. Noda and aides earlier this year about their concerns of a Chinese military threat. While China has reached agreements with other countries to encourage investment in its bond market and to encourage convertibility from the yuan into other currencies, this appears to be the most comprehensive such bilateral package. The moves suggest the two leaders may now see the need to downplay political differences and focus on reinforcing their economies, particularly at a time when Europe’s debt turmoil and flagging global growth threaten Asian growth.

The Wall Street Journal adds that while the deals may not have an impact anytime soon, they signal China’s willingness to make its currency more flexible:

Even so, the move is likely to be quietly welcomed by the U.S. government, which has encouraged China to seek a bigger role for the yuan. That’s because U.S. government officials realize—as do Chinese reformers—that for the yuan to play a much bigger role, China needs to broadly revamp its financial-sector policies. Morris Goldstein, an economist at the Peterson Institute of International Economics in Washington D.C. said those policies would include sharply reducing its exchange-rate intervention, liberalizing interest rates, reducing restrictions on capital flows and putting its banking system “on a more market-oriented basis,” so the yuan can trade freely.

Such policies are likely to put upward pressure on the yuan versus the dollar, which has long been U.S. policy. According to Chinese state television, Japanese officials notified Washington of the agreement ahead of the announcement and reiterated Japan’s confidence in the long-term prospects for the dollar. A U.S. Treasury spokesman didn’t comment.

China’s Ministry of Foreign Affairs denied the possibility of any near-term yuan appreciation in October, though it hit a record high against the U.S. dollar on Monday.