It's the Bank of Japan, not the Fed, that might change course because of China's shock devaluation

Since the People’s Bank of China started cutting the yuan’s value against the dollar earlier this week people have been preoccupied with how that might affect the Federal Reserve’s upcoming decisions.

But the Fed is probably not the major central bank that will pay most attention to moves in the Chinese currency.

There’s a good reason to think that the change in the PBoC’s approach will have a bigger effect on Japan’s monetary decisions than on the United States’, which can be summed up pretty well by this graph from analysts at Citi:

The Chinese yuan makes up closer to 30% of Japan’s trade-weighted currency index, compared to more like 20% for the United States and less than 10% for much of Europe. In short, changes in the yuan have a considerably bigger impact on the yen than the dollar or the euro. Japan’s economic policymakers want a relatively weak yen, and a weaker yuan makes that harder.

According to Bloomberg, Koichi Hamada, influential economic adviser to Japanese Prime Minister Shinzo Abe, said that “the magnitude of China’s shock is much larger than that from Greece, but we need not worry because always the effect of Chinese devaluation can be offset,” hinting that further easing from the Bank of Japan would be appropriate.

Here’s another snippet from Bloomberg’s report:

“It’s becoming hard not to expect additional easing,” said Masamichi Adachi, an economist at JPMorgan Chase & Co. and a former BOJ official. “China’s weakness is certainly bad news for Japan.”

The yuan’s devaluation will tend to put upward pressure on the yen, cutting import costs and making it harder for consumer prices to rise, Adachi said.

Twenty-one of 37 economists in a Bloomberg survey last month forecast the BOJ will eventually add to its record stimulus, with 12 predicting action in October.

The Bank of Japan has already engaged in massive monetary easing.

Though the Swiss National Bank has a larger balance sheet as a proportion of the country’s GDP (due to its huge purchases of euros in recent years), the BoJ stands out even against the Federal Reserve, European Central Bank and Bank of England.

Here’s how that looks:

An Oxford Economics research note argued that the yuan’s fall is yet another reason to expect a larger QE programme from the Bank of Japan:

China’s policy moves have made a further boost to the Bank of Japan’s QE programme more likely as this would almost certainly trigger a further fall in the yen. Our call is for the annual rate of asset purchases to be increased to ¥100trn from the current ¥80trn in October. We see the yen at ¥130/$US1 by early 2016 — from ¥125 today.

Analysts haven’t all taken that view about the Bank of Japan, but there’s no dispute that the decisions made about the yuan have a bigger impact on Tokyo than they do on Washington.

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