WHY DID THE YEN BECOME A RESERVE CURRENCY?

       Japan is the secondlargest economy in the world, with US$4.8 trillion (Bt 163.7 trillion) in GDP, after the United States ($14.3 trillion), as measured at the end of 2008. Because she has continuously run current account surpluses, she also has the largest net foreign exchange position, namely more foreign exchange assets than liabilities, with $5 trillion in gross foreign exchange assets and net $3.1 trillion in net foreign exchange assets at the end of September 2008.
       By contrast, China had $4.4 trillion in GDP, gross foreign exchange assets of $2.3 trillion and net foreign exchange assets of $1 trillion at the end of 2007. In other words, Japan still has three time larger net foreign exchange assets than China even though China has more foreign exchange reserves.
       In the 1960s, when the yen was still fixed at 360 to the $1, the Japanese economy grew at an average of 10 percent per annum. In the 1970s, when the yen began to appreciate and there was an oil shock, the growth slowed to an average of 5 percent. However, there was a massive stock market and real estate bubble after the Plaza Accord of 1985, when the yen appreciated sharply from 239 to the dollar to 128 in 1992. It continued to appreciate till April 1995 when the yen hit 80 and then went into reversal until it depreciated to 147 in June 1998, stopped only by joint intervention by the Bank of Japan and the US Treasury.
       According to economic textbooks, a country with a continuous surplus should have an appreciating currency. It is interesting to note that Japan had a continuous current account surplus despite the volatile yen. Indeed, Japan had to export capital in large amounts in order to keep the yen at a competitive level. In the 1980s, Japan began to internationalise the yen in an effort to make it a reserve currency and Tokyo an international financial centre. However, after nearly 17 years of dismal economic growth, when growth was at best between 12 per cent a year, the role of the yen had declined, whilst the number for foreign companies listed on the Tokyo Stock Exchange had also declined.
       Why did the yen not succeed as an international reserve currency? After all, Japan had actively promoted the yen by granting considerable amount of cheap official aid in yen loans. Japan banks branched overseas in the 1980s and granted substantial yen loans abroad. Because yen interest rates were cheap, initially many countries borrowed in yen, but very soon discovered that the high volatility in the US dollar-yen rate made the yen quite costly to hedge and to borrow.
       The reason why the yen was pushed as an international reserve currency and Tokyo as an international financial centre was strategic. Given an ageing population, Japan wanted to diversify from a manufacturing exporter to a surplus country with longterm income from its savings. If the yen was an international reserve currency, the Bank of Japan could earn seigniorage, namely an interest-free loan from foreigners using the yen as reserve currency. Furthermore, Tokyo could earn services income as an international financial centre dealing with yen securities, currency trading and commercial services.
       So the failure to achieve major reserve currency status despite the wealth and industrial power of Japan was strange. There are three conditions for becoming an international reserve currency - the value of the currency should be stable, transaction costs should be low and transparency should be high. Unfortunately, the Japanese yen has been very volatile and transaction costs in dealing in yen were also not cheap.
       The volatility in yen was due to several reasons, mostly from wrong policies. Firstly, Japan's position as a major exporter of yen meant that there was a yen "overhang". A Japanese investor in US treasuries earning a spread of say 4 per cent between US Treasury rate and Japanese deposit rate would find that his income would be wiped out if the yen appreciated more than 4 per cent a year, which happened quite often.
       The Thai borrower in yen, however, would find that an appreciation in yen would also wipe out the lower borrowing cost of yen compared to borrowing in Thai baht or US dollars. The borrower, however, would be naturally hedged if he earned an income in yen.
       But because of the longterm tendency of the yen to appreciate, Japanese exporters preferred to export in yen and import in dollars, thus protecting their income in yen terms and saving on import costs if the yen appreciated.
       This practice of passing the foreign exchange costs to the borrowers made the yen more volatile, because when the yen began to appreciate, both the borrower and the investor sold dollars to buy yen to protect themselves from the appreciation, causing the yen to go through large swings.
       You can be a reserve currency only if you have a wide variety of financial and real assets to purchase at attractive yields with liquid markets. Because of the massive asset bubble in Japan in 1989, the basic trend of financial assets and real estate has been downward, and yields on Japanese bonds, stocks and bank deposits are low under the near zero interest rate policy. Hence, dollar/yen turnover has steadily declined to 13 per cent of global foreign currency turnover in 2007 compared with 20 per cent in 1998. The position of the yen as a reserve currency was further pushed aside with the rise of the euro in 1999.
       Next, we shall look at the reserve currency status of the euro.