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Sino-Japanese conflict could stop Tokyo from intervening and push yen to record levels

The escalation in tensions between China and Japan could lift the yen to record levels against the dollar and prevent Tokyo from intervening in the FX market.

The spat over the possession of three islands in the East China Sea has been the catalyst for a rekindling of the burning animosity between China and Japan, which has its roots in Tokyo’s refusal to admit its atrocities during the Second World War. That has spawned anti-Japanese demonstrations, which some believe might have been orchestrated by the authorities in Beijing. That has spread to other arenas, with sources telling EuromoneyFXNews that Chinese state businesses have halted doing business with Japanese banks.

Escalation would likely lead to further strength in the yen, an event that would cause consternation at the Bank of Japan (BoJ), which has only just implemented a further round of quantitative easing aimed in part at reining in the strength of its currency.

On the face of it, that might seem surprising, given the trade links between the two countries – China is a leading market for Japanese exports, while Japan is one of the biggest investors in China and its tech industry relies on imports of Chinese rare earths.

 Japan-China total merchandise trade

 Source: CEIC

However, the yen’s strength would be a result of the fact that Japan is the world’s biggest net lender.

“What we forget is that any losses domestically are always mitigated by a transfer of funds from abroad,” says Neil Mellor, strategist at Bank of New York Mellon.

“It could be that any crisis, and it’s almost a perverse thing to say, could precipitate yen strength because capital is brought home. People underestimate that.”

Steven Saywell, head of FX strategy at BNP Paribas, concurs that an escalation of tensions would drive the yen higher, sparking haven demand for the currency.

“The yen tends to weaken when Japanese investors recycle their surplus and invest abroad, when there is strong confidence in the domestic economy,” he says. “Clearly, this is a situation where the Japanese will be keeping their money at home.”

Saywell believes, in any case, that USDJPY is on a weakening trend despite this week’s BoJ easing, given that US yields are set to remain low. He says the dollar is set to suffer more than the yen from easing by their respective central banks because the Federal Reserve has a bigger arsenal at its command and is more committed to using it.

He is not alone in holding a bullish yen view, but investors have been nervous about opening substantial short USDJPY positions on fears it might trigger intervention from Japan’s ministry of finance (MoF) to weaken its currency.

That prospect would become remote, however, if tensions between China and Japan escalated and Tokyo had to call for military assistance from the free-market-loving US, the biggest critic of MoF currency intervention.

“In that environment, the last thing the Japanese would want to do is poke fun at the Americans and intervening in USDJPY would not be a sensible thing to do,” says Saywell.

It is to be hoped things do not get that far and a solution to the dispute can be found. However, if one is not, then expect the yen to surge higher.

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