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Why China Won’t Use Its Financial Might to End Islands Row

Talk that China, the biggest holder of Japanese government bonds, may sell its Japanese debt to force Tokyo to cede ground in a heated islands dispute will remain just that, say analysts, with Beijing unlikely to pursue a course of action that could prove harmful to its own economy.

Anti-Japanese demonstrators hold banners and shout slogans as they protest over the Diaoyu Islands issue, known in Japan as the Senkaku Islands, outside the Japanese embassy in Beijing.
Mark Ralston | AFP | Getty Images
Anti-Japanese demonstrators hold banners and shout slogans as they protest over the Diaoyu Islands issue, known in Japan as the Senkaku Islands, outside the Japanese embassy in Beijing.

Jin Baisong, an official at the Chinese Academy of International Trade, a branch of the Chinese commerce ministry, caused a stir last week when he wrote in the China Daily, a Chinese Communist Party newspaper, that China should use its clout as a big holder of Japanese debt to impose sanctions and punish Japan.

China watchers say the comments reflect a perception within and perhaps outside China that Beijing can use its economic power to achieve its foreign policy aims. China is the world’s biggest holder of foreign currency reserves valued at more than $3 trillion, which it uses to invest in assets overseas such as U.S. Treasurys and Japanese bonds.

The view, however, is misguided, analysts say and the reality is this: China invests in foreign bonds because that is part of its economic policy. Holding foreign bonds allows Beijing to control its currency, and withdrawing money from Japan by selling Japanese debt would mean it has to look for another place to park its cash since bringing it home could spark an unwanted and sharp rise in the yuan.

“There is a perception in China that the currency reserves confer a power on the Chinese government that could be used as a weapon,” said Patrick Chovanec, an associate professor at Tsinghua University in Beijing.

“But that is not true. China buys foreign bonds because it has its own economic policy goals to pursue. It buys foreign bonds to keep the yuan from rising. So if it sold one country’s bonds it would have to buy another’s and doing this has its own risks so the only one it could end up hurting is itself,” Chovanec added.

There was a time when holding Japanese bonds had low appeal because of the country’s generally weak economic growth and large debt burden. But in recent years, concerns about the outlook for the U.S. economy and a debt crisis in the euro zone have prompted investors to view Japanese government bonds or JGBs as a relative safe haven.

China, for one, has gradually been increasing is holdings of Japanese debt – at the end of last year it held $231 billion dollars of Japanese bonds, a record high, according to Japanese government data.

“The decision on what to do with China’s FX reserves is taken by technocrats that have a mandate for economic considerations,” said Tim Condon, Head of Research for Asia at ING Financial Markets in Singapore. “And those decisions are not volatile — in fact they are almost etched in stone, so I wouldn’t expect a change in these considerations because of the dispute with Japan.”

The Yen Factor

Tensions between Japan and China flared up after Japan bought three disputed islands in the East China Sea earlier this month, triggering violent protests across China last week and threatening economic ties between Asia’s two biggest economies.

Still, in the unlikely scenario that China does sell a chunk of its Japanese bond holdings, the move should be cheered by Tokyo rather than condemned, analysts say. That’s because selling Japanese debt would lead to a weakening in the yen – something Japan’s policy makers have been hoping to achieve for some time now.

“Even if China decided to sell Japanese debt, the worst that could happen is that they drive down the yen, which is what Japan has been hoping to do itself,” said Chovanec. “Actually, Japan has said in the past it does not want China to increase its holdings of Japanese debt because it pushes up the yen’s value.”

Strength in the yen – which earlier this month hit a seven-month peak against the dollar and moved within 3 percent of last year’s record highs – is hurting Japan’s exporters and threatening to derail an economic recovery. The Bank of Japan’s decisionlast week to embark on asset purchases to stimulate growth was widely viewed as a move designed in part to weaken the yen.

Analysts say while the dispute between China and Japan over the islands, known as Senkaku in Japan and Diaoyu in China, should not be underestimated, the economic implications appear limited for now.

China is the number one market for Japanese exports and Japan is the number two market for Chinese exports.

“At the end of the day, both countries are important to each other. It’s hard to see how they will allow this to escalate further,” Andrew Pease, Global Head of Investments at Russell Investments in Sydney told CNBC Asia’s“Cash Flow” on Monday. “It is destabilizing, but it’s hard to see that this is going to have significant trade and economic implications as it’s in neither country’s interest to do that.”

- By CNBC's Dhara Ranasinghe

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