China and Japan reached an agreement on what is being referred to as a currency pact in December. As part of the agreement Japan will hold Chinese bonds as part of its foreign exchange reserves. Tokyo will purchase about $500 million worth of Chinese government bonds this year. Japan will likely add yuan slowly to its forex reserve, building its yuan holdings to around $10 billion over the next five years. The small size of the Chinese bond market will limit the pace of accumulation. Currently the US dollar makes up 80% - 90% of Japan’s forex holdings. By adding yuan-denominated bonds to its reserve holdings Japan will join the ranks of Nigeria, Malaysia, Thailand, and Chile.
This will help lift the status of the yuan to a ‘hard currency,’ making it a store of value. This pact is an important step in diversifying foreign exchange reserves away from the US dollar helping to significantly raise the yuan’s profile progressing the emergence of China’s yuan as a new global reserve currency. It is a starting point in a diversification trend. Following on the heels of this news, Japanese pension funds and insurance companies could also emerge as buyers of Chinese government bonds. The pact also raises the possibility that other emerging Asian currencies could be viewed as investable assets for foreign economies. This also lifts Japan’s status as a foreign exchange trading hub.
This deal was a major financial development over the holidays even though the markets did not appear to make much of the new. It could also be viewed as a strategic shift in relations for the two rivals. China’s dim sum bond market is estimated at $30 billion. The currency pact could help soothe the concerns of Japan’s policy makers about the fairness of Chinese access to Japanese markets. The pact could also help Japan gain insight and influence in China. Market intelligence could be achieved by these modest investments.
The Chinese yuan is slowly on the rise and it would appear Japan is trying to ride the waves. There are several ETFs that provide direct exposure to these countries. The Global X China Financials ETF (NYSEARCA:CHIX) provides maximum exposure to financials in the Chinese market. The WisdomTree Dreyfus Japanese Yen Fund (NYSE:JYF) provides leveraged exposure to the yen. The iShares MSCI Japan Small Cap Index (NYSEARCA:SCJ) is a greatly undervalued Japanese ETF. Any of these selection of ETFs would provide well distributed exposure to the Chinese and Japanese currency markets, which should soon be profiting from this new currency pact between the two nations.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.