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Monday, May 29, 2006

JAPANESE PERSPECTIVES

Getting to the bottom of foreign currency reserves


In recent months, news about sharp rises in foreign currency reserves held by emerging economies has been making headlines in Japanese papers.

China's forex reserves hit $875.1 billion at the end of March, topping Japan's $852 billion, while the combined reserves of the so-called BRICs -- Brazil, Russia, India and China -- topped the total reserves of the Group of Seven major industrialized economies.

I would like to point out, however, that the significance of the foreign currency reserves held by developing and industrialized countries differs for each, and that comparing the figures is meaningless. In this sense, Japan is unusual as a developed economy in that it has massive foreign currency reserves even though its own currency is convertible.

What should be noted first is that behind the drive by developing countries to build up foreign currency reserves is their external debts -- short- and long-term borrowings, outstanding bonds, and foreign investments, either direct or in securities.

Aside from some oil-producing nations, most developing countries are net debtors whose external debt exceeds their credit. What is still fresh in our memory is that the Asian financial crisis of the late 1990s was triggered by a rapid pullout of the foreign capital that had been pouring into the region. It is therefore more important to look at a country's external debt and credit positions than its foreign currency reserves.

Second, a country cannot use its own currency to pay for imports if it lacks convertibility. Such nations need to accumulate foreign currency reserves -- as Japan did after its defeat in World War II.

During the late 1940s, Japan's forex reserves dipped below $2 billion -- just enough to pay for three months' worth of imports -- only to be saved by a boost in demand caused by the outbreak of the Korean War.

Even after that, however, Japanese monetary policy remained closely linked to its foreign currency reserves. When the economy picked up, imports increased and ate into the reserves, prompting the Bank of Japan to raise interest rates.

So countries whose currencies lack convertibility need to build up sufficient foreign currency reserves. After the 1997 Asian monetary crisis, many countries in the region have been trying to keep more reserves on hand than they used to.

On the other hand, developed economies whose currencies are convertible have little need to stockpile reserves. In fact, China and Hong Kong together accounted for 22.6 percent of the world's total foreign currency reserves. Asian countries not including China and Japan accounted for 21.9 percent, with the other developing economies holding 23 percent.

Four Mideast countries that benefit from high oil prices -- Saudi Arabia, the United Arab Emirates, Kuwait, and Qatar -- accounted for 1.4 percent. Japan had 19.9 percent, and the other industrialized economies accounted for 11.1 percent.

Given the convertibility of the yen and Japan's status as the world's largest net creditor, Japan stands out as an exception, being an industrialized country with excessive foreign currency reserves.

Why?

Because the experience of the foreign currency shortage of the postwar years -- when Japan kept its economy afloat with exports and welcomed a weak yen -- is still deeply embedded in the nation's economic structure.

With the rapid aging of the population, the savings rate will decline as people tap into their savings, which the government has transformed into foreign currency reserves.

The foreign-exchange reserves should be squeezed and the surplus funds channeled to address domestic needs -- such as improving housing, airports and other infrastructure so they are on par with the western nations -- to ensure a better life for the people.

This is the real purpose of structural reform, and only when this is achieved will Japan truly become an advanced economy.

Teruhiko Mano is a professor at Seigakuin University Graduate School.


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