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Monday, Nov. 20, 2006


How Japan can avoid hostage situations in a globalized economy

When international tensions mount, foreign currency-denominated external credit and debt can become tools of diplomacy. If a country is a huge net creditor, its overseas assets can be taken hostage.

One example is the decision by the United States in 1950 to freeze China's dollar-denominated assets based on the Foreign Assets Control Regulation after Beijing gave military support to North Korea during the Korean War.

To evade the tactic, China converted its foreign currency reserves into British pounds. But since the pound's value was dropping against other major currencies at the time, China had to report appraisal losses on its forex reserves in succeeding years.

In the process of finding a solution to the asset-hostage situation, then Chinese Premier Zhou Enlai contacted the Bank of Tokyo, where I was working at the time as chief of the foreign-exchange section. The ensuing effort culminated in an agreement in August 1972 for conducting yen-yuan settlements between the Japanese and Chinese governments.

The accord, which allowed the use of a sort of open account trade settlement formula that did not rely on the dollar, expanded bilateral trade and contributed to the normalization of diplomatic relations. The yuan was then valued at 135.84 yen. Today, it is worth about 15 yen -- roughly one-ninth of the exchange rate in 1972.

Regrettably, Japan lacks measures to control the risks presented by its external assets. Net external assets -- the government's foreign currency reserves combined with the private sectors' overseas assets minus debts -- total $1.5317 trillion, far higher than other countries.

China's huge forex reserves, which surpass Japan's and are set to hit $1 trillion, have caught the attention of the media. But its external debt is also growing in the form of borrowings from overseas and foreign direct investment into the country, and its net external assets stand at $287.5 billion -- or roughly one-fifth of Japan's. This is where today's China differs from the China of 1972.

If China's overseas assets are frozen, Beijing can freeze foreign-owned assets in its own country in retaliation. It is also reportedly shifting its foreign currency holdings from dollars to euros in a likely attempt to minimize the stakes of any "hostage" situation that could involve the United States.

With its huge current account deficits, the United States has external assets of $10 trillion and debts worth $12.7 trillion, leaving it $2.7 trillion in debt on a net basis. Britain has a net debt of $371 billion. The net external assets of Germany, which like Japan successfully rebuilt its economy after World War II, stand at $269.2 billion.

There are three ways Japan can avoid being taken hostage.

First, Japan needs to boost the inflow of funds into the country, thereby increasing its external debt. To make that possible, Japan needs to make its economy more attractive to foreign investors.

To promote more deregulation and reduce the budget deficit, Japan must increase the efficiency of the public sector. Interest rates, which are still effectively in negative territory today, must rise.

Second, Japan must export less and import more. There is much more room for Japan to use production resources at home to improve the quality of airports, roads and housing. A policy to pursue a strong, yen which would boost the external purchasing power of individuals and corporations, will be key in achieving this goal.

And finally, Japan should try to increase yen-denominated trade and investment. This will boost both external assets and debt, and at the same time increase the value of any hostage that it decides to take.

All these efforts require changing Japan's collective mind-set in terms of economic globalization. It needs to ditch the belief that exports are good and imports bad, a belief that guided the country during the reconstruction phase Japan entered after the war.

The structural reforms achieved by the administration of Junichiro Koizumi marked the first stage of these efforts. The second stage will unfold under the direction of Prime Minister Shinzo Abe.

Teruhiko Mano is a professor at Seigaku in University Graduate School.

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