With the results of second quarter GDP, China has passed Japan to become the world’s second-largest economy behind the United States, finally laying to rest the long-held theory that a nation cannot depreciate its way to economic prosperity.

To be more specific in the case of China, what is now evident is that a nation can create prosperity by preventing its currency from appreciating and by artificially raising the value of competitor’s currency, the recent goings on vis a vis Japanese government bonds being just the latest case in point.

In June, China extended its record buying spree of Japanese debt, purchasing a net $5.9 billion of short term bills. As a result of all these bond purchases, the Yen has appreciated dramatically even as its economy limps along barely above water.

The recent surge in buying of Japanese bonds by the Chinese has stirred talk that China may be diversifying its foreign reserves into the yen and away from the euro and the dollar, which is of course what China wants the world to think. The real reason is much simpler; appreciate the yen and eliminate a competitor in exports.

China’s plan is apparently working as well as hoped-Japan’s economy expanded at the slowest pace in three quarters for the period ending June 30, rising at just a 0.4% annualized pace, as company’s like Sony and Toyota see their profits threatened while the yen rises to a 15 year high against the dollar.

China, much like everyone else, is concerned that the nascent global recovery will weaken going forward as the U.S. fails to make a significant dent in its unemployment rate, an assessment that seems to be all the more likely as time goes on.

To give you an idea of how dangerous the situation is for Japan, Honda’s CFO said on Aug. 5 that “if the Japanese economy is forced to create a production structure based on 85 yen to the dollar, that would be disastrous,” as the nation wouldn’t earn enough from exports to pay for commodities from overseas.

As you can see on the attached CNY/JPY chart, the yen has appreciated by nearly 7.5% against the yuan since the beginning of May, a move which is completely out of touch with economic fundamentals. But there is no country willing to criticize China on this issue because the global economy is becoming ever more dependent on China to fuel growth. The U.S. passed on its latest chance to label China a currency manipulator in June, even as the Secretary of the Treasury said the U.S. was hoping to see China allow its currency to appreciate vs. the USD!

©2010 FX Instructor Forex Blog - For Traders, By Traders. All Rights Reserved.

.