Although the Japanese yen is increasingly being used in international transactions, its use is still rather modest compared to the US dollar and the deutsche mark. Why?
George S. Tavlas and Yuzuru Ozeki
Japan’s phenomenal economic success as the world’s largest net creditor nation in recent years has provoked increasing demands that it accept broader international responsibility. Thoughts have turned to the possibility of a tripolar international monetary system, centered on the US dollar, the deutsche mark, and the Japanese yen. In such a system, other countries’ currencies would be pegged to one of these three, and the three “core” currencies would float against each other. If this occurs, it would represent a substantial modification of the international monetary system. In this connection, some have suggested that a yen zone is emerging in Southeast Asia, whereby the increased use of the yen in Asian regional trade and financial transactions will contribute to its use as an anchor currency. Eventually, it is suggested, the outcome could be an Asian monetary union, with the yen serving a similar function to that of the deutsche mark in the European Monetary System.
A longer discussion on this topic, by the authors, IMF Working Paper (WP/91/2) entitled “The Japanese Yen as an International Currency,” is available from IMF Publication Services, Washington, DC 20431, USA.
The rationale behind these views is apparently convincing. During 1983-89, Japan’s cumulative current account surplus amounted to about $415 billion, making that nation the world’s largest net international supplier of capital. Japan’s net long-term capital outflows totaled about $620 billion, or some $205 billion more than the cumulative current account surplus (see chart). The balance has been financed mostly by short-term capital inflows. This situation, whereby Japan has emerged as a net supplier of long-term capital and a net borrower of short-term capital, is analogous in some respects to the position of British banks in the late 19th and early 20th centuries and to that of US banks in the post-World War II period. During those earlier episodes, British and US banks served as bankers to the world, exporting long-term capital denominated in sterling and the US dollar, respectively, and borrowing short-term capital from the rest of the world, also in terms of sterling and the US dollar. The willingness of foreigners to hold liquid liabilities denominated in sterling and the US dollar allowed those currencies to serve as international currencies, enhancing the liquidity of the international monetary system.
But contrary to the growing expectations of the role for the yen in the international monetary system, the implications for the yen’s use in international transactions are mixed. Despite Japan’s emergence as the world’s largest net creditor nation, its capital outflows have not significantly facilitated the yen’s internationalization because capital flows (both short-term and long-term) have been primarily denominated in currencies other than the yen. The evidence suggests that the share of international trade transactions denominated in yen is much smaller than the currencies of other large industrial countries. Further, although there appears to be a relatively wider use of the yen as a regional currency in Asia, a yen-zone does not appear to be emerging. This article explains why this has happened, briefly discussing the necessary conditions underlying the international use of a currency and the role of Japan as an international financial intermediary.
Japan’s cumulative current account surplus and net long-term capital outflows
Source: International Financial Statistics. IMF.
International currency use
The uses of a currency in the international monetary system are analogous to, albeit more complex than, those of a national currency serving as a unit of account, means of payment, and store of value (see “International Currencies: The Rise of the Deutsche Mark” by George Tavlas, Finance & Development, September 1990). But whereas money is determined by government fiat in the domestic context, the choice of currencies to be used for international transactions is predominantly the result of market-determined processes. A major benefit is provided to a country whose currency becomes international. The issuing country derives seigniorage because the foreign claims built on it are denominated in its own currency. The country can, therefore, inflate away a portion of its nominal debt.
Several factors are necessary for a currency to be used internationally:
• As explained by Robert Mundell: “It is a fact of historical tradition that the top currency is provided by the top power” (“International Monetary Options,” The Cato Journal, Spring 1983, page 189).
• There needs to be confidence in the value of a currency and, therefore, in the issuing nation’s inflation performance. High and variable inflation generates nominal exchange rate depreciation and uncertainty.
• The country should have deep, open, and broad domestic financial markets. For example, a well-developed bankers’ acceptance market contributes to the amount of trade financed in a currency, and thus, to trade invoicing in that currency. Correspondingly, active short-term (e.g., Treasury bill and commercial paper) markets contribute to the international demand for currencies, reflecting central banks’ and other investors’ preferences for liquid and safe financial instruments.
• The larger a nation’s share of world exports, and the greater the extent to which those exports are denominated in the exporter’s currency, the greater the demand for that currency by foreigners in order to pay for imports.
How has Japan performed on the basis of the above criteria? Japan’s strong economic performance has allowed the nation to re-emerge as a world economic and political power. Moreover, during the 1980s, Japan recorded lower consumer price inflation (at 2.5 percent per annum) than the other large industrial countries. In addition, Japan registered the third lowest level of inflation variability; at 2.2 percent, it was only slightly above that of Switzerland (1.8 percent) and Germany (2.1 percent). In recent years, Japan has carried through a number of measures to broaden its financial markets and to ease access to those markets by foreigners. Finally, during the 1980s, Japan’s share of world exports rose by 2½ percentage points (reaching over 9 percent by the end of the decade), a larger increase than any other major industrial nation. Moreover, the direction of Japanese trade moved progressively toward Asian developing countries, paving the way for a larger regional use of the yen.
But certain problems remain. Despite recent efforts to liberalize Japanese financial markets, some areas are still subject to restrictions. For example, the Treasury bill market is not very active, the commercial paper market is not yet well developed, restrictions on some euro-yen investments remain, and trading in the government repurchases market is complex. Further, a number of factors have inhibited the yen’s use in international trade, including: (1) Japan’s share of exports to developed countries (particularly the United States) has increased and is likely to be denominated in these countries’ own currencies; (2) Japanese exporters apparently have sought to denominate their trade in foreign currencies, while absorbing reduced profit margins during periods when the yen has been appreciating against those currencies, so as to maintain their market share. (When the currency of an exporting nation appreciates, its exports sales typically fall, because the appreciation raises prices in terms of the importing nation’s currency. Japanese exporters, however, have often kept the foreign currency price of their exports unchanged, maintaining their sales level, but reducing their profits.); (3) the absolute level of Japanese exports to non-Asian developing countries fell during the 1980s, impeding the yen’s use in trade, since developing countries tend to denominate their imports in foreign currencies; and (4) the bankers’ acceptance market is not well-developed, making it difficult for Japanese firms to obtain trade financing in yen, hence curtailing the yen’s use as an international unit of account and medium of exchange.
The pattern of a nation’s capital flows shows how international currencies emerge, given the existence of the necessary conditions for international currency use described above. For example, if foreigners are acquiring short-term claims (i.e., supply short-term capital) in the currency of a particular country, it implies that the country possesses a large supply of short-term, relatively high-yielding financial instruments denominated in its own currency, the access to such instruments is relatively free from controls, and foreigners attach a relatively high degree of certainty to that nation’s currency. Foreigners may demand short-term claims denominated in such a currency in part for liquidity and investment, or to pay for imports denominated in that currency. The nation’s ability to attract short-term capital enhances its capacity to supply longer-term loans denominated in the nation’s currency to the rest of the world.
If the nation meets these conditions, it can function as an international financial intermediary (i.e., a world banker). In conjunction with its role as a world banker, the growth of a nation’s liquid liabilities can exceed that of its official reserves. As Charles Kindleberger and Peter Lindert noted with respect to the financial intermediary role of the United States in the 1950s, the nation’s liquid liabilities were growing faster than its reserves, but it also had “such extensive longer-term, less liquid, assets abroad that the nation was a heavy net creditor to the rest of the world overall .... [Thus] the United States was acting as a financial intermediary, lending long and borrowing short” (International Economics, Homewood, Illinois, 1978).
Japan as world banker
Japan’s role in the global allocation of capital flows has increased markedly in recent years, reflecting both its current account surplus—the counterpart for the nation’s excess of saving over domestic investment—and its emergence as an international financial intermediary. In 1985, Japan became the world’s largest holder of net external assets. Moreover, by the end of 1989, Japanese residents had accumulated net external assets of more than $290 billion, up from an average of about $30 billion in the first half of the decade. Almost 60 percent of Japan’s foreign claims were long-term, while over 60 percent of the nation’s liabilities were on the balance sheets of its banks and were short-term. Also—in line with the Kindleberger-Lindert view—the ratio of Japan’s short-term liabilities to official reserves rose sharply during the course of the decade.
But has Japan’s international intermediary function contributed to the willingness of foreigners to hold liquid liabilities denominated in yen? Not really. In contrast to the earlier cases of the United Kingdom and the United States, which borrowed short-term and lent long-term primarily in their own currencies, commercial banks in Japan have been involved chiefly in maturity transformation of external funds—that is, borrowing short-term funds overseas in foreign currencies (mostly US dollars) and investing funds in long-term instruments overseas denominated in foreign currencies. Because the regulated Japanese financial market to some extent limited the rate of return on financial instruments (relative to rates available in some other financial centers), Japanese financial institutions have sought to invest substantial funds in other industrial countries in nonyen denominated instruments; in the late 1980s, about 75 percent of Japanese net long-term capital outflows were directed to industrial countries.
Japanese banks, as well as some nonfinancial corporations, have capitalized on their good credit standings in the international capital market, borrowing short-term funds to acquire long-term bonds overseas. Although external lending by Japanese banks increased during the 1980s, the share of yen-denominated lending—though rising—remained less than one third of the total throughout the decade. Further, direct investment to developing countries comprises less than 5 percent of Japan’s net capital outflows, and most of that has been directed toward Asian developing countries. Thus, the processes underlying the emergence of sterling and the dollar as international currencies, whereby developing (and reconstructing) countries accumulated sterling- and dollar-denominated balances (for liquidity and investment, to pay for imports invoiced in those currencies, and to service loans for capital development denominated in those currencies), appear to be less significant in the case of the yen (except in the case of Asian developing countries).
Since Japanese banks lend largely in foreign currencies to take advantage of higher yields abroad, why do the banks also borrow primarily in foreign currencies? One reason, noted earlier, is the absence of a well-developed bankers’ acceptance market and the fact that both exports and imports are predominantly denominated in currencies other than yen. Consequently, banks often borrow short term to make “impact loans” (foreign currency loans to domestic firms) to finance trade. Second, such borrowing possesses several advantages over yen-denominated borrowing in Japan. For example, the reserve requirement on all foreign-currency liabilities to nonresidents, regardless of duration or size, is lower than reserve requirements applicable to yen-denominated deposits and, unlike rates paid on other types of deposits, which are often regulated, interest rates on foreign currency deposits are set freely by the market. Third, the existence of prudential regulations limit banks’ net foreign exchange exposure. Specifically, banks’ combined net foreign exchange exposure cannot exceed a narrow limit (positive or negative) at the close of each business day. Thus, if banks lend in foreign currencies, prudential regulations prompt the banks to also borrow in foreign currencies.
Although Japan has been channeling funds to the rest of the world, that process has not necessarily been conducive to the yen’s international use. Since foreigners have not been accumulating yen-denominated loans, they have had relatively little incentive to accumulate yen-denominated claims to pay back such loans. Further, the fact that the Japanese financial market has been (until recently) tightly regulated, and remains narrow and thin in some areas, has also discouraged the holding of short-term, yen-denominated claims by foreigners.
The yen’s use ...
As an invoicing currency in trade. Recent data trends confirm the expectation that the yen’s use as an international currency, although increasing, is still rather modest. The proportion of Japan’s exports denominated in yen rose from 17.5 percent in 1975 to 40 percent in 1983, before declining to about 35 percent in the second half of the 1980s. By contrast, about 96 percent of US exports are denominated in US dollars, while national currency invoicing of exports by the major European countries is in the range of 40-80 percent (with Germany having the highest proportion). The share of Japanese imports denominated in yen rose steadily, from less than one percent in 1975 to about 14 percent in 1989, but was still well below the proportion of imports invoiced in the local currencies of the United States (85 percent) and the major European countries (27 percent to 52 percent) at the end of the 1980s.
In regional trade transactions. Yen-invoicing of exports to Southeast Asia declined over 1983-89 (seeTable 1), but yen-invoicing of imports from Southeast Asia rose sharply. Nevertheless, the proportion of imports invoiced in yen (at 20 percent) from Southeast Asia does not suggest that a key regional role is emerging for the yen in Asian trade transactions.
As a medium of exchange. Turning to the use of the yen in international financial markets, the yen’s share of external bank loans rose sharply until 1985, reaching 18.5 percent, but subsequently declined to 5.5 percent—about the same as its share during the first part of the 1980s. Regarding external bond issues, the share of the yen rose from less than 6 percent in the first part of the 1980s to over 8 percent in the second half of the decade (although the yen’s share declined in 1988 and in 1989). Finally, the share of the yen in the denomination of eurocurrency deposits rose from under 2 percent in the early 1980s to 5.5 percent in 1989. Since 1987, the yen’s share of each of these three international markets has declined.
As a currency used by official agents. The importance of currencies as international units of account, medium of exchange, and stores of value can also be gauged from their use as official reserves. The yen’s share of foreign exchange holdings has consistently been higher in Asian countries than in the world at large in recent years (seeTable 2). Between 1980 and 1989, the yen’s share of official reserve holdings among Asian countries rose sharply; in the late 1980s, about 18 percent of such holdings were in yen. However, a far greater proportion (56 percent) was held in US dollars and a substantial share (15 percent) was held in deutsche mark. By contrast, European countries hold about 25 percent of their reserves in deutsche mark and only about 5 percent in yen. Thus, the data indicate that the yen’s regional use by official agents, though growing, is considerably less than the use by official agents of the deutsche mark within Europe.
|Selected Asian countries||13.9||15.5||22.8||17.5|
|Selected Asian countries||48.6||55.7||48.4||56.4|
|Selected Asian countries||20.6||16.7||16.7||15.2|
The yen’s emergence as an essential component of the international monetary system is directly related to its role as a key currency within Asia. Although the yen’s use as a regional Asian currency has increased in recent years, the data pertaining to both Japan’s trade invoicing and to official currency holding by Asian countries indicate that a yen-zone does not appear to be emerging. Whether a yen currency bloc will emerge in the foreseeable future depends importantly on the openness, the breadth, and depth of the Japanese financial system. In this connection, recent measures to deregulate Japan’s financial markets and to free the nation’s capital flows augur well for the yen’s international use. The implementation of additional measures will allow Japan to emerge as a world banker in the traditional sense, so that Japan’s capital outflows and inflows are conducted increasingly in terms of the yen, enhancing that currency’s international and regional status.