Study Group for the Promotion of the Internationalization of the Yen (June 30, 2000)

Introduction

The report of theCouncil on Foreign Exchange and Other Transactionsentitled "Internationalization of the Yen forthe 21st Century" (released in April 1999;hereinafter referred to as the "ForeignExchange Council Report") identified theurgent need to promote the internationalization ofthe yen against the background of changingdomestic and international economic and financialconditions, such as the 1997 Asian currencycrises. The report also contained a wide range ofpolicy recommendations pertaining to the promotionof the internationalization of the yen. (Theserecommendations are as follows : i) achievingstable growth in the Japanese economy andrebuilding the financial system, stabilizing thevalue of yen, and reviewing the yen's role inAsian countries' exchange system; ii) improvingthe financial and capital market environmentsincluding settlement systems to enhance the yen'sconvenience; iii) reviewing current practices intrade and capital transactions, examining the useof the yen from new perspectives.)

The Study Group forthe Promotion of the Internationalization of theYen was formed in September 1999 to follow-up onthe above report, and to undertake research andinvestigations pertaining to policy measures forfurther promoting the internationalization of theyen.

The Study Group hasmet on five occasions and engaged in an activeexchange of thoughts and opinions. Furthermore,the following Sub-groups were formed under theaegis of the Study Group to examine specificissues: Sub-Study-group for Trade and CapitalTransactions (7 meetings), Sub-Study-group forResearch on Currency System (5 meetings), andWorking Party for Research on Settlement Systems(3 meetings).

The Study Groupwill continue its research and investigationregarding such issues as policies for thepromotion of the internationalization of the yen.This report is a summarization of the issuesdiscussed thus far which are expected to be ofcentral importance in the future deliberations ofthe Study Group.

1. Improvementof Convenience in Procurement and Management ofYen Funds

(1) Regarding theissue of improving convenience in procurement andmanagement of yen funds, in light of thedeliberations of the Council on Foreign Exchangeand Other Transactions, the Ministry of Financeannounced several specific measures for thepromotion of this objective in December 1998,including the start of open market bidding on newFBs (short-term government bonds) and the reviewof current tax systems. In addition to this,various recommendations were contained in theForeign Exchange Council Report. In line withthese developments, the following policy measureshave been implemented thus far. It is hoped thatthese actions will lead to an increase in theprocurement and management of yen funds bynon-residents.

(2) The Study Groupbelieves that it must actively examine the variousrecommendations of the Foreign Exchange CouncilReport concerning U.S. and European styles of repotransactions, strips bonds, and reform ofsecurities settlement and clearance systems.Regarding tax exemption of JGBs interest accruingto non-residents instituted in September 1999, theStudy Group believes that it is important topromote the investments in JGBs by non-residentsthrough so-called "global custodian"(financial institutions which contract with majorinstitutional investors and provide unifiedcustodial services, proxy exercise of rights andreceiving of principal and interest payments forinternational securities on behalf of theinvestors diversifying internationally theirportfolios). In order to promote investments inJGBs by non-residents, in view of actual tradingswhile maintaining an appropriate taxation, it isnecessary to expedite the deliberations of theStudy Group to reach conclusions as early aspossible and to act towards the appropriateresolution of these issues.

(3) As suggested inthe Foreign Exchange Council Report,"promotion of more efficient yield curvesthrough improved market-interest indices for allmaturities for government bonds is a prerequisitefor the international utilization of yenassets." Improving the government-bondsecondary market constitutes an extremelyimportant factor in the internationalization ofthe yen. As noted above, various measures havealready been implemented in this direction.However, continued efforts must be made to furtherimprove the government-bond secondary market.

2. Review ofCurrency-Denomination Practices in Trade andCapital Transactions

(1) The followingpoints were made in the Foreign Exchange CouncilReport: "Given the ongoing and major changesin domestic and international economic conditions,it is necessary to review past practices and toexamine the use of the yen from newperspectives." "There is a growing needto re-evaluate the risks and costs associated withthe choice of currency, to review past currencychoices in trade transactions, and to examine thepossibility of expanding the use of the yen inindividual transactions."

(2) The Study Group's Sub-group for Trade andCapital Transactions has reported that a newpossibility for yen-denominated transaction isemerging as a consequence of the followingdevelopments.

The Sub-groupreports that, following the above, such firms astrading companies and manufacturers are developingfuture strategies for expanding theiryen-denominated transactions particularly in Asia.

The Sub-group alsoreports that issuance of yen-denominated bonds bynon-residents are increasing due mainly to thefollowing reasons : i) rising weight ofyen-denominated bonds in the bond index used byforeign investors and others in asset management;ii) reduction of the basis spread; iii) changes inU.S. hedging accounting principals (mark-to-marketvaluation of currency swaps); iv) increased demandfor procurement of yen funds as a result of theexpansion of direct investments coming into Japan.

(3) While the above developments are encouraging,in general, no clear signs are yet to be seenregarding the increase of yen-denominated tradeand capital transactions.

In May 2000, the KeizaiDoyukai (Japan Association of CorporateExecutives) released a report entitled "APrivate-Sector Perspective on theInternationalization of the Yen" (hereinafterreferred to as "Doyukai Report").Based on a series of questionnaires and interviewswith member companies and Asian countries, thereport summarizes the evaluation of the currentinternational status of the yen by Japanesecompanies as follows: "Many (Japanese)companies recognize that increasing the use of theyen under the current domestic and internationalpolitical and economic frameworks isdifficult." The evaluation of Asian countriesis summarized as follows: "There are alreadywell-established frameworks in Asia assuming theuse of the U.S. dollar in international trade andthere is no perceived imperative to increase theuse of the yen."

(4) Empirical studies of the foreign-exchangesensitive ratio of the revenues of major Japaneseindustries (foreign exchange risk exposure ratio)indicate that long-term trends in foreign exchangeexposure ratios have remained flat or haveactually risen somewhat since the middle of the1980s. In addition, very few Japanese companiespursue a policy of 100% neutralization of foreignexchange risks, indicating that foreign exchangefluctuations are in some instances viewed aspresenting positive business opportunities.However, it has been pointed out that "whenleaving portions of their risk positionsuncovered, doubts remain as to whether individualcompanies are basing their decisions on rigorouscost-benefit analysis of risk avoidance and riskacceptance." Thus, first of all, it isimportant to have a clear awareness of foreignexchange risks as a real risk factor.

(5) It has been argued that the very high weightof dollar-denominated transactions in Japaneseexports to the U.S. can be explained in terms ofPTM theory (pricing-to-market behavior). In otherwords, in opting for dollar-denominatedtransactions, Japanese exporters are attempting tostabilize the prices of their products in terms ofthe currency of importers so as to maximize theirexpected profits by maintaining a certain marketshare.

However, it isnecessary to remember that in order for PTMbehavior to result in profit maximization, certainconditions must be met concerning the demandfunction of export goods. While many empiricalstudies indicates that Japanese firms are actuallyemploying the PTM behavior, it is important todifferentiate between their actual PTM behaviorand the question as to whether such behavior isrational and profit maximizing.

It is highlyprobable that PTM behavior is rational forcompanies selling products which hold weak marketpositions and thus difficult to be differentiated.However, Japanese exports to the United Statesinclude many products with strong competitivepositions and which are highly amenable to productdifferentiation. In this connection, it isimportant to note that the share ofdollar-denominated exports to the United States islower for German exports than for Japaneseexports.

It has been pointedout that Japanese companies are shifting theirfocus from maximizing gross revenues toemphasizing profit and risk levels. In thiscontext, there is a growing need to review thechoice of currency while re-evaluating the risksand costs associated with such choices.

(6) Trading companies indicatedthat they supported the contention that thefollowing corporate strategies should be reviewedfrom new perspectives: financial strategiesassigning the responsibility for the management offoreign exchange risks to the head office, andmanagement strategies emphasizing gross revenues.On the other hand, it was also pointed out that,while the head office is involved in formulatingstrategies for minimizing risks for the entiregroup, the field offices face the challenge ofminimizing risks while responding to customerneeds and maintaining strategic pricing policies.Therefore, in the future, it will be necessary toexamine the various obstacles existing on thelevel of the field offices which may be hamperingthe increased use of the yen.

(7) An important issue to beconsidered is how to connect Japan's ample supplyof funds with the strong demand for funds whichwill be generated by continued economic growth inthe Asian countries. It has been argued that onereason why yen-denominated fund procurement hasnot grown is that the low ratio of yen-denominatedJapanese imports generates very littleyen-denominated cash flow. This may indicate thatthe expansion of yen-denominated imports is animportant key to promoting theinternationalization of the yen.

In this connection,it was pointed out that imports of primaryproducts should be denominated in yen when theproduct has been developed primarily for export toJapan and financed in yen.

Given thesignificant increase in the ratio of Japan'smanufactured imports and the continued growth ofdevelopment importing, there should be ampleopportunities for increasing the ratio ofyen-denominated imports in the future. Accordingto the questionnaire study conducted by KeizaiDoyukai (the Japan Association of CorporateExecutives), a majority of respondents said thatthere was a better chance of raisingyen-denominated imports than exports. Thus, forthe future, further attention should be paid tospecific measures for increasing yen-denominatedimports. The opinion was voiced that, in thisrespect, the expansion of Japan's domestic demandand the expansion of the absolute amount ofimports may also constitute importantconsiderations.

3. StrengtheningAsian Regional Cooperation

(1) The ForeignExchange Council Report makes the following point:"In promoting the internationalization of theyen, it is most realistic to begin with effortsaimed at boosting the use of the yen in Asia whichshares very strong economic ties with Japan."As such, for the time being, raising theyen-denominated ratio of trade and capitaltransactions with Asia constitutes the mostimportant issue. The question of how to increasethe use of the yen in Asia must be considered fromthe perspective of Asian partners.

(2) The Doyukai Report makesthe following points: "Asian countries arenot, overall, very interested in the yen'sinternationalization." "There arealready well-established frameworks in Asiaassuming the use of the U.S. dollar ininternational trade and there is no perceivedimperative to increase the use of the yen. Thereare even suspicions that Japan is attempting toshift the entire exchange risk to its tradingpartners, under the disguise of internationalizingthe yen."

(3) We must pay attention to thefact that the concept and presentation of the"internationalization" of the yencontains aspects which are based on primarilyJapanese perspectives. Needless to say, theinternationalization of the yen is not anessential concern for the Asian countries. Rather,what truly interests them lies as to howindividual Asian countries or the region as awhole can develop stable foreign exchangemechanisms, how to promote trade and capitaltransactions with Japan and other Asian countries,and finally, how the internationalization of theyen can contribute to these objectives. Therefore,Japan must begin by discussing the followingmatters with its Asian partners: What is the mostappropriate foreign exchange system for individualcountries? Or, what types of regional mechanismsshould be developed for stabilizing exchangerates? What role should the yen play in theseareas? What form of regional financial cooperationshould be pursued for achieving these objectives?By stabilizing the relation between the yen andAsian currencies through these endeavors, webelieve that the ratio of yen-denominatedtransactions will increase to reflect the currentvolume of trade and capital transactions inresponse to the improved convenience of theprocurement and management of yen assets, and thereview of current practices.

Note: The ForeignExchange Council Report makes the followingpoints: "The strengthening of theinternational role of the yen will contribute tothe stability of foreign exchange markets,particularly those in Asia, and to the stabilityof Asian economies." "It is importantthat Japan rapidly restore and expand its tieswith the real aspects of Asian economies throughtrade and capital transactions. Such transactionswould supply yen to the Asian region and establisha foundation for the circulation of yen ininternational transactions." The DoyukaiReport argues that the internationalization of theyen will benefit Asia as follows: "This willmake it possible to procure stable yen capitalfrom Japan, with its abundant capital surpluses,to meet the capital needs of Asian countries withtheir high growth potential."

(4) The pattern of trade in 1997 often Asian economies (the ASEAN4, the NIEs, China,and Japan) shows that 46% of exports and 50% ofimports were intraregional, meaning that theinterdependence of the Asian economies has becomequite strong. Dependence on trade of many Asiancountries is considerably higher than that ofEurope, and as referred to above, intraregionaltrade has grown to account for nearly 50% of totaltrade. In view of this, we believe that Asia isreaching the stage at which it should explore aregional currency stability mechanism that willensure that exchange rates in Asia reflecteconomic fundamentals, and move in a stablemanner.
Prior to the currency crisis, Asian countriesemployed a virtual dollar peg, which in turncontributed to maintain the stability of exchangerates within the region, and worked for afoundation for the development of regional tradeand investment. However, the currency crisisexposed the risk involved in exchange rate systemsvirtually linked to only one currency, the dollar.For Asian countries to achieve exchange ratestability in the region, it has become necessaryto build a new exchange rate stability mechanismto replace the virtual dollar link.

In view of factorssuch as the substantial differences in the stageof economic development of the countries of Asia,when considering a regional exchange ratestability mechanism it would -as in the case ofthe formation of a free trade area- be botheffective and realistic to adopt a multilayeredand phased approach in which bilateral agreementsand regional agreements are combined.
For example ASEAN countries have agreed toeliminate tariffs within the AFTA by the year2018, thereby completing the creation of afree-trade area. Europe's experience suggests thatto foster trade and investment in a free-tradearea the stability of exchange rate in the regionmay be more important than the level of tariffs,and thus a possible option for the ASEAN countriesis to link their exchange rates to a commoncurrency basket, while maintaining a sufficientlywide band. In this situation, we believe thatenhancing the linkage of Asian currencies and theYen relatively stabilize their exchange ratesagainst the Yen.

(5) With regard to the exchangerates of Asian countries it was pointed out thatregression analyses with the dollar, the yen, andthe euro showed that since the second half of 1998the regression coefficients have been returning totheir patterns prior to the currency crisis, andthat Asian countries exchange rate regimes arethus reverting to the regimes -virtually pegged tothe dollar- that existed prior to the crisis.

However, looking atthe movements of the regression coefficients wecan see that although the relationship betweenAsian currencies and the dollar has strengthenedagain, since the second half of 1998 there arealso phases in which the regression coefficient isdeclining, making the movement of coefficientunstable. Therefore, it cannot be concluded thatthe currencies have reached the stage of returningto the same pattern as before the currency crisis.Furthermore, regression analyses alone does notpermit the actual state of the exchange ratepolicies of individual countries to be adequatelygrasped. For example market participantsassociated with foreign exchange markets point outthat the exchange rate policy of the monetaryauthorities of the Republic of Korea is to giveimportance not only to stability against thedollar, but also to the yen.

Looking exchangerate of Asian currencies against the dollar andthe yen (standard deviation of the change from theprevious month), after the Asian currency crisisthe difference between against the yen and againstthe dollar is smaller than prior to the crisislevel, and against the yen has become relativelystable.

(6) In the course of surmountingeconomic difficulties in the wake of the currencyand financial crisis, common recognition of theimportance of regional cooperation has grown amongAsian countries. Based on this common recognition,an informal ASEAN + 3 (Japan, China, Republic ofKorea) summit was held in Manila in November 1999,where a joint statement on East Asia cooperationagreed to "strengthen policy dialogue,coordination and collaboration on the financial,monetary, and fiscal issue of commoninterest." That was an extremely importantfirst step towards strengthening regionalcooperation in Asia.

At the ASEAN + 3meeting of finance ministers held in Chiang Mai inMay 2000, agreement was reached on expanding theASEAN Swap Arrangement and building a network ofbilateral swap and repurchase agreement facilitiesbetween ASEAN, China, Japan, and the Republic ofKorea (the Chiang Mai Initiative), based on theagreements at the November summit.
In view of factors such as the diversity of Asiannations, in strengthening the framework forregional cooperation between monetary authorities,it would be both effective and realistic to buildnetworks for multilayered financial cooperation byexpanding and combining the bilateral andmultilateral cooperation.

The officialreserves of the ASEAN + 3 countries total morethan US$ 700 billion (at the end of 1999). In ourview it would be highly meaningful for thestability of the region's currency and financialmarkets if the countries participating in thisframework were to engage in closer monetarycooperation by using a portion of their officialreserves. With regard to currency swaps usingAsian currencies and repurchase agreements usingAsian government bonds, if these are carried outin conjunction with steps such as the developmentof direct foreign exchange markets between Asiancurrencies and the building of currency settlementsystems, they may have favorable consequences suchas the expansion of transactions between Asiancurrencies.

Note: Regarding thecurrency settlement systems which reduces thesettlement risk in exchange transactions byrealizing PVP (Payment versus Payment) offinancial settlement, two types of the system canbe considered. One is "multi-nettingsystem" that centrally settles pluralcurrencies, and the other is "direct-linksystem" that links each central bank systemin two countries. We believe this is the issue tobe examined taking into account the amount oftransactions and the stage of development of eachcountry's settlement system.

(7) In view of these situations,lately released reported by the "Subcouncilon the Revitalization of the Asian Economy andFinancial Markets" of the Council on ForeignExchange and Other Transactions emphasizes theimportance of regional efforts, and recommendatedthe promotion of intraregional trade andinvestment, exchange rate stability, the promotionof policy dialogue, and building a financialcooperation network in the region.
These factors to strengthen the cooperationnetwork in the region have the possibility of notonly improving convenience in procurement andmanagement of yen funds, but also changing thestructure about selecting the internationalcurrency in Asia.

4. ComprehensiveStrategies toward the Internationalization of theYen

(1) It is widelyargued that the use of an international currencyas a medium of exchange is subject to inertialforces. That is, international currencies aresubject to a form of "economies ofscale" arising from the positive feedbackeffects such as the choice of an internationalcurrency due to its low transaction costs (basicconvenience), and further reduction intransactions costs which derives from a wider useof the currency (increased convenience).

Note 1: The ForeignExchange Council Report points out that "Theuse of a currency in international transactionsis, in certain respects, subject to stronginertial forces."

Note 2: Whileinternational currencies function as a store ofvalue, as well as a medium of exchange, the dollarhas remained a key currency notwithstanding thefact that it has been suffering a secular declinein value. This is an indication of the importanceof international currencies as a medium ofexchange.

(2) Such inertial forces can inturn exert a reverting feedback effect on theinternationalization of the yen (transaction costsare high because the yen is not widely used, andhigh transaction costs further discourage the useof the yen). In fact, these inertial forces aregenerating the following types of negativefeedback effects.

(3) The following point has been made with regardto international currencies subject to inertialforces. "Unless substantiated by the realeconomy, switching the trading currency from theU.S. dollar to the yen will merely mean increasedtrading costs. Private companies operate inpursuit of profit, and they cannot switch from thedollar to the yen so long as such a switch meansgreater exposure to exchange risks and highertrading costs." The following opinion wasalso voiced by private-sector participants in thediscussions of the Sub-Group for Trade and CapitalTransactions. "The choice of atrade-settlement currency is based on 'economicrationality.' The decision not to use the yen isthe result of such a rational process."

(4) Insofar as international currencies aresubject to inertial forces, the choice of theinternational currency (key currency) thateveryone else is using may represent the"rational economic" choice forindividual entities, notwithstanding the foreignexchange risks that such a choice may entail.However, there is no guarantee that such a choicerepresents the rational economic choice for thesociety as a whole. As pointed out in the ForeignExchange Council Report, the internationalizationof the yen can be expected to generate variousadvantages in terms of stabilizing theinternational monetary system and stabilizing theAsian economies, while also contributing to theJapanese economy in various ways. It is noteworthythat the internationalization of the yen has notprogressed notwithstanding these advantages.

(5) The following three types ofstrategies may be considered for breaking out ofthe current impasse.

The first strategyentails modifying the general framework in whichthe choice of international currencies is made sothat the use of the yen will represent a rationaleconomic choice for individual economic entities.

The ForeignExchange Council Report points out that "inpromoting the internationalization of the yen, itis vital to improve the general environment forthe use of the yen in international transactionsand to enhance confidence in the yen." Inthis connection, the Report contains variousrecommendations for upgrading the financial andcapital market environments and making necessaryimprovements in settlement systems. Suchrecommendations should be implemented as soon aspossible. Special members of the Foreign ExchangeCouncil's "Sub-Council on the Revitalizationof the Asian Economy and Financial Markets",who joined the discussions from various part ofAsia, pointed to the need to improve theconvenience of the procurement and management ofyen funds as a prerequisite to raising the weightof the yen in the currency baskets used by theAsian countries.

In this connection,the Doyukai Report contains the followingpoints: "Advancing the internationalizationof the yen have to be complemented by measures inthe real economy that will heighten the need forthe yen's greater use." "It must bestressed that success in steadily implementingmeasures needed to deepen the interdependence andcooperation in Asia is a prerequisite for theinternationalization of the yen." "Ifsuch cooperative interdependence can bestrengthened, there will be more intra-regionaltrade. It will be more important thatintra-regional currency markets be stable, andconsequently, conditions will come to favor theemergence of an intra-regional lead currency oranchor currency." As such, the DoyukaiReport argues that Japan must cooperate with Asia"both the government and the private-sectormust make every effort to strengthen economicrelations and intra-regional cooperationthroughout Asia."

The second strategy relates to the review as towhether past currency choices really represent"rational economic" choices. Suchreviews would be undertaken by individual economicentities when a major structural shift hasoccurred, by one factor or other, pertaining tothe choice of international currencies. Some haveargued that "Given the existence of a defacto standard pre-supposing the continued useof the dollar, the internationalization of the yenwill not proceed even if its convenience issignificantly improved." Nevertheless, it isknown that a de facto standard benefitingfrom the "economies of scale" mayundergo a rapid shift in face of domestic andinternational environmental changes.

As indicated in theForeign Exchange Council Report, "Given theongoing major changes in domestic andinternational economic environments, it appearsthat it is now necessary to review past practicesand to examine the use of the yen from a newangle."

The third strategy featurescooperative action, that is, a unified andcontinuous effort on the part of the governmentand the private sector to promote the increaseduse of the yen. The Foreign Exchange CouncilReport states: "It will be necessary for thegovernment and private sectors to undertakevarious efforts and reviews, including therevision of the conventional perception of theyen. Also, an awareness must be developed thatthis is an issue to be addressed over the longterm toward the 21^st century." Anargument was made by the Foreign Special Membersof the aforementioned Sub-Council of the ForeignExchange Council that the internationalization ofthe yen requires regional undertakings in Asia.

(6) However, given theabove-mentioned strong inertial forces ofinternational currencies, we believe that it willnot be possible to break out of the currentimpasse by adopting only one of the above threestrategies or by implementing some of therecommendations contained in the Foreign ExchangeCouncil Report. Based on unified actions(coordinated actions) taken by the government andthe private sector, the internationalization ofthe yen requires the implementation of variousmeasures which aim to achieve such goals as theimprovement of the convenience of the procurementand management of yen funds, and the strengtheningof intra-regional Asian cooperation. Again,long-term and patient efforts are required of allparties as they continuously review their currentpractices and examine the use of the yen from newperspectives.

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