Japan's banks suddenly hold huge leverage over China's economy

With the financing of much of Asia's trade and the flows in and out of its various financial centers still heavily dependent on Japan, Japan's bankers, squeezed between an overheating U.S. and an increasingly troubled China, have a difficult balancing act to perform.

Since the 1990s, Japan's big banks have had a very large and growing deposit base but limited domestic demand for credit, forcing them to look overseas for profits in international capital markets, which are dominated by dollars.

To grow overseas, Japanese banks needed vast amounts of dollars. Fortunately, there was a solution in the Eurodollar market, and this is where things get more complicated.

Simply put, Eurodollars refer to the market for dollars outside of the U.S., which operate quite differently to America's onshore dollar market. Almost a synthetic version of the real thing, Eurodollars can and often do behave differently at times of stress.

The reason is, as Russia is learning to its cost, that most national currencies like dollars and related assets, such as U.S. Treasury bonds, never actually leave the U.S. Even China's vast holdings of more than $1 trillion of U.S. Treasurys ultimately exist as electronic ledger entries in the U.S. financial system and can be frozen at the press of a button.

Using dollars outside America requires a complicated system of interbank loans, where what is used and traded are claims on dollars that remain in the U.S. system rather than actual, let alone physical, dollars themselves.

The first step of this chain often starts in London. Bankers in Tokyo will pledge yen as security for loans and receive Eurodollars in return, enabling them to make loans or buy assets in dollars. In turn, Japanese banks will usually demand some sort of security or collateral for these loans. This can vary from U.S. securities to real estate to the commodities that underlie trade finance.

Because borrowing in Eurodollars is more expensive than borrowing onshore in America, Japanese banks must find higher-yielding returns to offset this cost. This naturally forces them toward higher-risk lending.