JAPAN: Two steps back

Prospects for regional financial cooperation in Asia have taken a severe knock with potentially serious disputes over physical territory erupting between Japan and China and between Japan and South Korea. These disputes have begun to spill over from the diplomatic and political arena into aspects of the three countries’ economic and financial relations.

The timing of the events is unfortunate for Tokyo, which earlier this year reached agreements with its two neighbours on various monetary issues – currency cooperation involving the yen and the Chinese renminbi in particular. Tokyo is also hoping to promote itself to the world as a centre for global investment in emerging markets.

“I am less optimistic than at any time in many years about regional [economic] cooperation because of these territorial disputes,” says Takatoshu Ito, dean of the Graduate School of Public Policy at the University of Tokyo. “I don’t see any solution because at this point none of the [parties] seems willing to back off.”

The disputes involve claims and counter claims by Japan and China over sovereignty of the remote but potentially resource rich — in terms of undersea gas and oil deposits — Senkaku Islands in the East Japan Sea, and similar claims between Japan and South Korea over the Takeshima islets which are situated equidistant between the two countries.

South Korea president Lee Myung-bak triggered the latest flare-up in the long-simmering disputes when he visited Takeshima in August, prompting a sharp retort from Japanese prime minister Yoshihiko Noda and causing then finance minister Jun Azumi to threaten the tearing up of a currency swap and government bond buying agreements between the two countries.

Shortly afterwards, the Senkaku dispute re-ignited, leading to the arrest by Japan of Chinese activists who visited the island, and then to sometimes violent anti-Japanese demonstrations in various Chinese cities. Sino-Japanese economic relations are feeling the strain, Japanese motor manufacturers car makers and other businessmen have reduced exports to and production in China.

Trade between Japan and its largest trading partner China, worth around $24 billion annually, is expected to suffer significant damage.

Noda failed to hold hoped-for bilateral talks with the Chinese president Hu Jintao and with South Korean president Lee during the Apec (Asia-Pacific Economic Cooperation) summit in Vladivostock in early September because of regional tensions caused by the territorial disputes, and a planned free trade agreement among the three countries has been put on hold.

“This sort of thing spills over to political and even economic cooperation,” says Ito, a former deputy vice finance minister for international affairs. Progress among Japan, China and South Korea on the Chiang Mai Initiative Multilateralized (Asia’s regional monetary fund) and on the Asian Bond Market Initiative (which aims to develop liquid and efficient bond markets in Asia) could suffer, he says, adding that “momentum is being lost.”

Japan’s vice finance minister for international affairs Takehiko Nakao tells Emerging Markets that “the recent problems between Japan and China and Japan and Korea are not encouraging.”

“I don’t want these problems to damage the achievement of people in these countries,” Nakao adds. Before the disputes erupted, the outlook for regional monetary cooperation in north-east Asia appeared to be the brightest in years. Japan and China had agreed at the highest levels to seek ways of making the yen and the yuan respectively more easily tradable in both countries, as well as agreeing to mutual purchases of each other’s government bonds.

Operations were established in mid-year in Tokyo and in Shanghai for trading yen for yuan directly in the respective cities. Trading appears to have got off to a very slow start, although how much of that is due to economic or political circumstances is not clear. Most trades continue to be conducted through the dollar, notes chief foreign exchange strategist Tohru Sasaki at JPMorgan Chase Bank in Tokyo.

NEW RESERVE CURRENCY

A more important development for Japan is the fact the Bundesbank has decided to open a currency operation in Tokyo (in addition to the German central bank’s regional supervision office). This appears to be connected with accelerating diversification of leading central bank reserves into the yen and certain other currencies such as the Australian dollar.

“Many central banks now are trying to diversify their foreign exchange reserves,” one dealer says. “It’s because they are worried about the dollar and about the US fiscal situation, and definitely worrying about the European situation. The yen has become not just a temporary haven for capital fleeing the euro and the dollar but is assuming a growing role as an alternative reserve currency. The problem is that there is not much choice.”

The world’s four largest bond markets are the US and the euro bond market, followed by Japan and the UK. “So if you have a relatively large amount of foreign reserves, there is not much choice for diversifying,” the dealer says.

The Japanese Government Bond (JGB) market is clearly benefitting from flows of central banks and other investment into the yen, despite concerns over Japan’s yawning fiscal deficit and the fact that the ratio of outstanding government debt to GDP has reached an unprecedented level of around 200%.

“It is true that many people are worried about the Japanese fiscal situation, but if you invest in short-term bills it’s not so risky,” says JPMorgan’s Sasaki. “Overseas investors have started looking at short-term Japanese bills, and I think the share of foreign holdings in short-term Japanese bills is 16–17% now.” Foreign holders’ share of all JGBs has hit a record high of over 8% this summer.

For Japan, this is a mixed blessing. It implies that the yen is likely to remain strong in the longer term as central banks and leading institutional investors diversify increasingly into yen. That is bad for Japanese exports and for Japan’s chronic deflation, but it could help spur the restructuring of the economy away from manufacturing and exporting and more towards services, which many economists claim is needed.

Among these, financial services is an area in which Japan has signally failed to make its mark, even in regional let alone global terms, compared to other financial centres such as London and New York or Hong Kong and Singapore. This is despite the fact that Japan has some 1,400 trillion yen ($17.5 trillion) of household savings.

The need for further deregulation and liberalization (along with the relatively poor English language ability of most Japanese) is a significant barrier to Tokyo’s development as a financial centre, but the IMF/World Bank meetings could nevertheless help to open the eyes of the global financial community to Japan’s potential in this regard, says Sasaki.

“Lots of emerging market economists will come to Tokyo. There is a very good demand from clients for the meeting, and emerging markets have been a very important issue. Many Japanese institutional investors and corporates are interested in these markets. It could be that the meeting could serve as a trigger to expand interest in emerging markets among Japanese investors and corporates.

“Some investors are still shy about investing in emerging markets, but [this meeting] may provide a good opportunity to start thinking about it,” he says.