Commentary: Currency Quid Pro Quo

Japan's offer to help in Iraq means the U.S. is likely to accept a deal on the yen

The big showdown. That's what currency traders would normally expect to see when Japanese Prime Minister Junichiro Koizumi and President George W. Bush get together on Oct. 17 in Tokyo. After all, Treasury Secretary John Snow effectively confronted Japan on Sept. 20 when he orchestrated a Group of Seven call for "flexible exchange rates" -- diplo-speak for an American demand that both Tokyo and Beijing let their currencies appreciate against the greenback. China's yuan, which trades at a fixed rate, hasn't budged -- and likely won't anytime soon. But since the G-7 announcement, the free-floating yen has soared. In response, after a hiatus of just a few days, Japan again intervened in the currency markets by buying dollars, and has done so several times since. Koizumi, after all, needs robust exports to keep the fragile Japanese recovery going. And, of course, the U.S. wants a weaker dollar to boost American exports and keep jobs.

So is the stage set for serious disagreement? Don't bet on it. In the Bush Presidency, geopolitics trumps economic politics. And Koizumi is playing his geopolitical cards very shrewdly.

The Japanese Prime Minister is positioning himself as a willing contributor to rebuilding Iraq. At considerable risk at home, Koizumi is expected to pledge more than $5 billion over four years for Iraq reconstruction. Japan is also considering deploying 2,000 peacekeeping troops to the strife-torn country to support U.S. forces. Good news for Bush, who has been savaged for his failure to line up international donors to help pay for the postwar cleanup and send reinforcements for bloodied U.S. troops.

Of course, even as the American public balks at the price of getting Baghdad back on its feet, there's equal consternation about the 2.7 million U.S. jobs vaporized on Bush's watch, many of them manufacturing slots that moved to Asia. As jobs disappear in America, Japanese cars and electronics continue to flood the U.S. But Koizumi now has the political cover he needs to ignore U.S. manufacturers yelping about the yen. Putting Japanese citizens at risk would give him enormous leverage over Bush. Thanks to help on Iraq, figures Barclays Capital Chief Economist Mamoru Yamazaki, "it will be a lot easier to intervene in the currency markets" if the yen continues to push the envelope.

So don't be surprised if the Japanese prove undeterred in their determination to weaken the yen or at least slow its rise. As of Sept. 30, Japan had spent $120 billion buying dollars in 2003. On Oct. 5, Japanese Finance Minister Sadakazu Tanigaki vowed "decisive action" if the currency rose much beyond its recent level of about 110 yen to the dollar -- already 7% above the rate Tokyo had managed to maintain through most of the year. Other Finance Ministry officials are discussing raising the current $720 billion cap on government borrowing to fund currency interventions. That would allow for an additional $90 billion in dollar purchases between now and Mar. 31.

Bush is sure to talk tough on the currency front, but in the end he'll almost certainly accept Koizumi's position. He knows that Koizumi needs to keep the yen under control or risk squelching Japan's nascent recovery. If the yen climbs too high, exporters such as Sony (SNE ), Toyota (TM ), and Matsushita (MC ) will see their profits pinched, which could force them to scale back investment plans. The rising currency already has stemmed the flow of foreign capital into Japan's financial markets, taking the wind out of the Nikkei's rally. Foreigners were net sellers of Japan stocks in the first two weeks of September.

The U.S. President gets another benefit from Tokyo's currency maneuvering: It's no secret that the Bank of Japan and other Asian central banks are the main prop under the U.S. Treasury bond market. This Asian appetite keeps U.S. rates moderate and aids the U.S. recovery. So look for Koizumi to put up serious yen and troops to help his buddy out of his Middle East jam. In return, he will want some studied inaction by Washington as Japan's financial authorities pull out the artillery again.

By Brian Bremner

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