Wednesday, October 29, 2008

Why the US dollar remains the default world currency, and the Japanese cling to it

Understanding why the US dollar remains the safe haven that it is necessitates that we understand the psychology and incentives of other developed nations. This is a very compelling piece by R. Taggart Murphy on why the US dollar remains the default currency reserve of the world. He maintains that the most likely contender for the role, the yen, is being consciously prevented by the Japanese from achieving such status.

Saori Katada poses a most compelling question: why does Japan continue to denominate so much of its accumulated export earnings in dollars? Supporting the dollar is largely a matter of using the dollar as the primary settlements and reserve currency for your foreign trade and investments, which the Japanese have done since 1945 -- first because they had no choice and then, from the early 1970s on, as deliberate policy…. Katada notes that there has been a good deal of talk emanating from Tokyo about the "internationalization" of the yen, but until Japanese companies begin to denominate their export earnings in yen -- which means billing foreign customers in yen and redeploying export profits in yen -- that's all it is: talk.

Murphy correctly points out that keeping the yen from attaining a substitute default standard to the US dollar has both costed the Japanese dearly, but has also enabled them to continue their policy of choice, which is to run trade surpluses.

Japan is the world's 2nd largest economy; it has been more than forty years now since the country needed to have any concern about its ability to afford essential imports...Why should such a country doggedly persist in a foreign exchange policy that looks as if it were drawn up for a weak, third world economy: hoarding "precious" foreign exchange as if any day now it couldn't pay for essential imports? Particularly when the dollar has lost more than two thirds of its value against the yen since the fixed link between the two currencies was cut back in 1973? And when Japan is facing a looming financial-cum-demographic crisis with a rapidly aging population and unfunded pension liabilities so large that the government has literally lost track of them? Those liabilities would be a lot less forbidding if Japan had systematically been salting away for the past few decades the earnings from its trade surpluses in yen and/or Deutschemarks and then Euros rather than in dollars.

Perhaps it's because those trade surpluses would not have been so large if Japan had switched from dollars 35 years ago. Katada argues -- and I would concur -- that that explains much. She notes not only the importance of the U.S. market to Japanese exporters -- billing American customers in any currency other than the dollar usually means losing those customers, something few Japanese exporters have been willing to risk -- but that most of Japan's other large trading partners in East and Southeast Asia also use the dollar as their primary external settlements and reserve currency.

So why do the Japanese allow its citizenry to remain stuck with a lower standard of living than they might otherwise enjoy by having a world-beating currency? Is it worth all the surpluses they end up with? Murphy explains further why:

A currency cannot be "internationalized" -- that is to say, widely used overseas -- unless it is available in sufficient quantities. Availability stems from outflows: either through the issuing country's current account of its international balance of payments, or through the capital account thereof. Outflows via the current account are, by definition, current account deficits. Outflows via the capital account mean that the country is deploying its surpluses overseas in its own currency in the form of loans to foreign borrowers, purchases of foreign bonds issued in the purchaser's currency, equity stakes in foreign companies, plant and equipment investments in foreign countries and so forth. But, for these loans and investments to make economic sense, the interest and dividend payments they generate -- not to mention principal repayments and profit repatriation -- have to be denominated in the currency in which the original investment or loan was made; otherwise they expose the investors to unacceptable foreign exchange risk. Thus the foreign entities that borrow the money or receive the investment have to have a way of earning the currency in which the loan or investment was originally made. As the foreigners use the capital deployed to make things or perform services that are sold back into the country that initially made the loan or the investment -- thereby earning the money needed to service the debt or repatriate the profits – the issuer of an international currency opens itself to the probability of periodic current deficits.

So the market took over from where the Japanese government was unwilling to do anything. Since they were unwilling to loan out their surpluses in the currency of would-be borrowers, the borrowers decided to borrow instead in yen. Who would be bold enough to take the currency risk? You’re right – speculators and hedge fund managers.

Among other things, there are now plenty of players prepared to find themselves short yen; that is to say, plenty of non-Japanese are now prepared to borrow yen. But that has nothing to do with long-term borrowings to build highways. It is opportunistic short-term borrowing by the likes of hedge fund managers who borrow yen at the next-to-zero interest rates that have prevailed since the mid 1990s and then flip the proceeds into a higher-interest currency such as dollars or baht. The practice is known as the "yen carry trade." The practitioners expect to profit from the interest rate differentials and bet that the yen will not appreciate significantly during the life of the borrowings. It's a license to print money provided, indeed, that the yen doesn't appreciate.

Another effect of the Japanese reluctance to de-dollarize their export earnings, according to Murphy, has been the decision to keep their earnings within the US financial system, which has been largely responsible for US ability to maintain military expeditions around the world, and I might add, for the US penchant to re-invest all this available liquidity in the latest asset bubble.

A systematic series of moves to "de-dollarize" as Katada puts it means dynamiting the key pillars of Japan's postwar political and economic framework: an economy structurally designed to generate current account surpluses, and the all-embracing alliance with the United States. By its willingness to hold its export earnings in dollars without seeking to exchange or repatriate them, Japan has left its export earnings inside the U.S. banking system, thereby automatically helping to finance American external deficits. Thus Japan has been the primary financial facilitator since the 1970s of the American ability to project military power around the world without crushing domestic tax burdens.

This is an unsustainable status quo, and both the dollar and yen will continue their extreme volatilities unless this is addressed. With the Japanese government still reluctant to take its long-due role on the world economic stage, what can we expect in the future? Murphy ends with: Of course the current meltdown on Wall Street -- not to mention the distinct possibility that a (new) administration may entrench the flailing, wild-eyed American militarism of the last seven years -- could well blow up that framework anyway without any help from Tokyo. But only then do I believe there will be any serious, thought-through effort to replace the dollar with the yen as Asia's pre-eminent currency.

(Murphy's original article appeared in MR Zine)


Abzal Kumar said...


Have to say I found the read very interesting. Do you know who roy murphy is? It would be very helpful to learn about his background and the inlfuences that form his opinion.

Rogue Economist said...

No, but you might ask MR Zine for an introduction. Accdg to them,
R. Taggart Murphy is Professor and Vice Chair, MBA Program in International Business, Tsukuba University (Tokyo Campus). He is the author of The Weight of the Yen and, with Akio Mikuni, of Japan's Policy Trap.