Currency deal ushers in a new era

China and Japan will start direct trading of their currencies on Friday in a move to boost trade ties between Asia's two biggest economies.

This will be the first time that China has allowed a major currency, apart from the US dollar, to trade directly with the yuan.

Direct trading of the currencies means that the two countries will not be using the dollar as an intermediary in setting exchange rates.

The China Foreign Exchange Trade System, the central bank's trading arm, announced the move on Tuesday. It said that a system to manage the direct trade of the currencies would be established.

This means that both countries will abandon the existing system, which calculates yen-yuan rates on the basis of their respective values against the dollar.

Yuan-yen trading will be processed on the Tokyo and Shanghai markets, and the daily yen-yuan central parity rate will be formulated by the weighted average of prices given by market makers, it said.

The move came after Japan said in December that it would become the first developed economy to hold yuan-denominated bonds as reserve assets. Tokyo got approval to buy about $10 billion of Chinese bonds in March.

Bank of China, a major international yuan clearing and settlement bank, said in a statement on Tuesday that it has applied for direct market maker qualifications. It also said that it had completed the risk monitoring and system preparation to guarantee sufficient liquidity in the inter-bank market for trading.

"In the future the exchange rate of the yuan against the yen will be determined directly by market demand and supply," it said.

The People's Bank of China, the central bank, said on Tuesday it "actively" supports the direct trading.

"This is an important step in implementing the joint statement of the leaders of the two countries on strengthening cooperation between China and Japan in developing financial markets and mutually promoting direct trading between the two currencies based on market principle," it said in a statement posted on its official website.

Direct trading will result in the establishment of a direct exchange rate between the two currencies, it said.

"This will help lower currency conversion costs for economic entities, facilitate the use of the yuan and Japanese yen in bilateral trade and investment, promote financial cooperation and enhance economic and financial ties between the two countries."

Lian Ping, chief economist at the Bank of Communications, said direct trading between yuan and yen would reduce dollar influence on the two currencies.

"And it will better reflect the supply and demand situation between the two economies and facilitate trade."

Japanese Finance Minister Jun Azumi also highlighted that the move will reduce transaction costs and lower risks when financial institutions conduct settlement.

China has overtaken the US to become Japan's biggest trade partner. In 2011, trade between China and Japan reached $344.9 billion, up 14.3 percent on the year.

Annual trade between China and Japan more than doubled in the past 10 years. Currently less than 1 percent of it is settled in yuan. Most is settled in dollars, according to the Japanese Finance Ministry.

"This is part of China's broader strategy to reduce dependence on the dollar. The yen has been chosen because of large trade flows between the two countries," Reuters quoted Dariusz Kowalczyk, senior economist and strategist at Credit Agricole CIB in Hong Kong, as saying.

"This could lead to an expansion of trade with other currencies and it will be easier for China to expand into other Asian currencies."

Although China aims to make the yuan a global currency, insufficient convertibility under the capital account means the yuan can only fulfill 10 percent of its potential international role, said Ma Jun, greater China chief economist at Deutsche Bank.

Direct trading of the yuan and yen does not mean full convertibility of the yuan, Liu Weiming, an analyst at China Citic Bank, said.

"As the two currencies are directly traded, the use of the yuan in settling trade between China and Japan will increase. And Tokyo is likely to become a yuan offshore center like Hong Kong, London and Singapore."

According to Japan's ministry of finance, yuan-denominated deposits and financial services are becoming increasingly popular in Tokyo.

Banks, such as HSBC, Bank of China and Standard Chartered, and Internet-based Japanese bank Jibun Bank, are beginning to accept yuan deposits by individuals. And Japanese lenders are also allowing domestic companies to hold yuan earned through trade as deposits, it said on Tuesday.

The currency's wider use is gaining strength as more than 9 percent of China's total trade was settled in yuan last year, up from only 0.7 percent in 2010.

The central bank signed currency-swap agreements worth 1.3 trillion yuan ($205 billion) with 14 countries and regions by the end of 2011 to expand the use of the yuan.

Anita Fung, chief executive officer of HSBC Hong Kong, forecast that in five years the yuan would become one of three major currencies most widely used to settle trade worldwide, together with the dollar and euro.

But for Chinese traders, it's difficult to say how popular the yen will be when they settle transactions.