The Fading Dream of Yuan-Yen Direct Exchange

One of the things people unfamiliar with currency markets do not fully appreciate--and these include poo-bahs alike Fred Bergsten of the Peterson Institute of International Economics--is that all currency pairs involve the US dollar and something else. To change Japanese yen into Chinese yuan for instance, you would typically refer to the USD/JPY exchange rate first to obtain dollars, then change the dollars to yuan via the USD/RMB exchange rate.

Recently, the Chinese and Japanese governments established mechanisms to bypass the need to exchange their currencies into dollars first. In other words, you could exchange yen for yuan and vice-versa straight without changing first into dollars. It sounds great in theory: why mess with dollars when you are doing trade within Asia, anyway? The transaction costs of not having to obtain dollars in the process should reduce the costs of foreign exchange.

However, things have not quite worked out that way it seems. Because the market in direct yen-yuan or yuan-yen foreign exchange remains thin or lightly traded, bid-offer spreads tend to be fat. In layman's terms, the prices at which traders are willing to sell yuan and buy yen--or buy yen and sell yuan in the opposite instance--differ markedly. OTOH, in an active market, the prices for both should be nearly identical since there are many buyers and sellers of both currencies competing with each other for business. That is, profit margins would be wafer-thin. As it so happens, the practice of intermediating yen-dollar-yuan or yuan-dollar-yen trades still comes out cheaper since the dollarless trading markets are illiquid. From the WSJ:

When direct dealing started, it met with great fanfare. Japanese finance ministry officials played up their high hopes for the shift and what a step forward it would be for Sino-Japanese economic relations. Following suit, the media extensively covered the move and brokerages started related new services...

According to Mizuho Corporate Bank, direct yuan-yen daily turnover is currently around ¥5 billion ($63 million), half the initial June level. That compares with total dollar-yen daily volume in Tokyo of $145.4 billion, based on the latest Bank of Japan figures released in July. 

OK...so the situation is not so promising--yet. What needs to emerge is an economy of scale that reduces transaction costs that quite frankly isn't there yet:

One misconception has been the idea that direct yuan-yen trading would automatically be cheaper than the two steps of yuan-dollar and dollar-yen trading combined. Traders say this can be true in theory, and may eventually happen, but for now the low trading volumes mean the single bid/ask spread is larger than in undertaking the two trades.

"The transaction cost is represented by the difference between offer and bid levels, not the number of trades to execute an order," said Junya Tanase, chief currency strategist at J.P. Morgan Chase Bank in Tokyo. The wider spread for yuan-yen trading reflects the low volume, creating a classic "chicken-and-egg" dilemma for those in the market. "Yuan-yen trading size must match at least euro-yen trading volumes for us to be able to use regularly," a major non-Japanese bank dealer in Tokyo said. That would mean that volumes would need to soar to more than $20 billion daily. 

Current yuan-yen turnover is $63 million, while commentators suggest that it would only be cheaper to do direct deals when turnover reaches $20 billion--a 317-fold increase. To make an understatement, the yuan has a long way to go before becoming a "medium of exchange" even in its own backyard.