As U.S. averts default, Japan and China brace for next dollar drama

Reuters

By Wayne Arnold and Leika Kihara

HONG KONG/TOKYO, Oct 18 (Reuters) - Deal or no deal, theU.S. Congress' dance with default impressed policymakers andinvestors in China and Japan with just how vulnerable their owneconomic revival plans are to the next political tantrum onCapitol Hill.

The 11th-hour agreement on Wednesday between CongressionalRepublicans and Democrats to raise the limit on U.S. governmentborrowing and end a 16-day government shutdown also averted adefault on U.S. Treasury bonds that had threatened the globaleconomy and financial system.

But Congress gets another chance to hold U.S.creditworthiness hostage early next year ahead of a new Feb. 7deadline to approve a debt ceiling increase.

"We're glad a deal has been struck," said a Japanesepolicymaker, who spoke on condition of anonymity. "But theuncertainty will remain and it will be the same thing all overagain early next year."

He and other Japanese officials say they have alreadydeveloped contingency plans that include flooding Japan'sbanking system with cash to keep markets functioning howeverpanicked investors become. And analysts say China, whoseCommunist leaders are due to hold a key policy meeting nextmonth, may step up a push for global acceptance of its currency,the yuan or renminbi, as an alternative to the U.S. dollar ininternational trade.

"They might actually consider accelerating the process,"said Vincent Chan, head of equity research at Credit Suisse inHong Kong. "You strengthen the case of making the renminbi agenuine international currency, because the Americans areunreliable."

NEAR-DEBT EXPERIENCE

Perhaps no two economies outside the United States have moreat stake in Washington's recurring drama than Japan and China.

Not only are they the second- and third-largest economies,but they lend Washington more money than any other singlenation. China held $1.28 trillion in U.S. Treasury securities atthe end of July and Japan owned $1.14 trillion. A default wouldlikely have devastated the value of their holdings.

More than that, though, both nations have adopted policiesto revitalise their own economies that to some extent rely onthe improving economic appetite, stable currency and increasingindebtedness of the world's largest economy.

China is trying to deflate a dangerous credit bubble andwealth imbalances with a series of reforms that include slowlyeasing controls on moving money into and out of the country andallowing its currency to gently appreciate.

Analysts predict investors faced with a U.S. default wouldtry to sell dollars for yuan, forcing China's central bank toeither buy up dollars at a time when the government issuing themisn't honoring its obligations or allow a rapid increase in theyuan's value that would hurt exports and worsen the country'scredit bubble.

"If China allows the yuan to rise sharply, it could be veryrisky given the possible asset bubbles in the country," said HeYifeng, an economist at Hongyuan Securities in Beijing.

Japan, meanwhile, is trying to end 20 years of deflation andanaemic growth with a blend of policies named for their chiefproponent, Prime Minister Shinzo Abe. "Abenomics" relies onreviving domestic consumption and investment in part byweakening the yen, boosting the earnings and stock prices ofgiant exporters like Toyota Motors Corp and Hitachi Ltd.

A U.S. default would likely prompt investors to buy yen.

"That would undoubtedly pose a headwind against Abenomics,which has much depended on a weak yen and higher share pricesbuoyed by the feel-good mood it has generated," said MasamichiAdachi, senior economist at JPMorgan Securities in Tokyo.

QUID PRO QUO

A default also stands to hamper U.S. recovery and with it anascent rebound in global exports. A default in the firstquarter of 2014 would hit just as Japan's economy girds for anApril sales tax increase and as China's economy loses theeffects of accelerated public works spending and re-stocking ofinventories.

There are no bond markets large enough to give China andJapan an alternative to U.S. Treasuries for the dollars theyaccumulate selling exports. So the prospect of another U.S.default drama next year is likely to lend new urgency to China'spreferred solution: conducting less trade in dollars and more inrenminbi.

About 18 percent of China's total trade is settled in yuanand it has registered a sharp increase this year afterstagnating for most of last year.

Much of the increase has come in China's trade witheconomies outside the United States or the European Union, itsbiggest demand centres, although it accelerated plans tointernationalise the currency with agreements this month withBritain and the European Central Bank.

Achieving more trade in yuan, however, means giving China'strading partners a place to invest their renminbi as easily asthey invest their dollars in U.S. Treasuries now.

That means opening China further to foreign investment, arealisation that could strengthen the hand of officialsadvocating faster reform.

"China can only be strong when its currency is a realalternative," said Chan at Credit Suisse. "But to be analternative you have to have an open market."

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