Since the second half of the 1990s, Japan has tried to promote the use of the yen as an international currency but has made little progress so far. Now, following in Japan’s footsteps, the People’s Republic of China (PRC) is promoting the internationalization of the renminbi. It would do well to consider why Japan’s attempt at internationalizing the yen has failed.
From reluctance to approval
Until the Asian financial crisis in the second half of the 1990s, Japan was reluctant to promote the internationalization of the yen, fearing that capital flows could destabilize the economy and render monetary policy ineffective, a problem widely considered to be the major cost for a country promoting the international use of its currency. In the second half of the 1990s, however, Japan’s stance shifted to approval. The change was prompted by the introduction of the euro as a common currency in much of the European Union, by the recognition of the need for Asian countries to reduce reliance on the dollar after the Asian financial crisis, and by the implementation of the Financial Big Bang intended to transform Tokyo into an international financial center on par with New York and London by 2001.
In a 1999 report titled “Internationalization of the Yen for the 21st Century,” Japan’s Ministry of Finance’s Council on Foreign Exchange and Other Transactions extolled the benefits from wider use of the yen for international transactions.
According to the report, viewed from an international perspective, the dollar, euro, and yen support the world’s three major economic regions. As such, the euro (representing Europe) and the yen (as the principal Asian currency) are in a position to complement the dollar. Such complementary arrangements can contribute to the establishment of a stable international monetary system supported by the sound economic policies of the United States, the eurozone and Japan. Strengthening the international role of the yen would contribute to the stability of foreign exchange markets, particularly those in Asia, and to the stability of Asian economies.
The report argued further that from a domestic perspective, the wider use of the yen in international transactions would vitalize financial markets in Tokyo, its home. The growth of yen-based international financial transactions and business would create new business opportunities for Japanese financial institutions and reduce the risks involved in borrowing and lending in foreign currencies. It would also effectively contribute to restoring and improving the competitiveness of Japanese financial institutions. Moreover, increased invoicing of international transactions in yen could reduce foreign exchange risk for Japanese companies.
Why internationalization of the yen failed
Notwithstanding the shift in Japan’s official stance, the yen has made little progress toward becoming a truly international currency. Since the mid-1990s, the share of Japan’s exports invoiced in yen remained flat at around 40% and the share of imports invoiced in yen remained flat at around 25% (according to Japan’s Ministry of Finance). In addition, the yen’s share of turnover in global foreign exchange markets dropped from 11.3% in 2001 to 9.5% in 2010 (according to Bank for International Settlements, “Triennial Central Bank Survey”). Finally, the yen’s share of the foreign reserves of the world’s central banks has dropped from 6.8% in 1995 to 3.8% at present (according to the IMF).
To be used widely in international transactions, a currency usually must meet the following three conditions: (i) the issuing country has a substantial presence in international economic and other spheres; (ii) the currency is convenient to use for international transactions, which presupposes its home country has deep, liquid, and open capital markets; and (iii) the value of the currency is stable.
The yen has not succeeded in becoming widely used as an international currency because none of these preconditions have been met since the government adopted its pro-internationalization stance.
First, Japan’s economic power declined markedly over the two “lost decades.” Japan’s share of world GDP fell from 17.8% in 1994 to 8.4% in 2011 (estimated, according to the IMF), while its share of world exports declined from 10.3% in 1986 to 5.1% in 2010. Along with Japan’s diminishing role in the global economy, the dependence of Asian countries on Japan as a trading partner also declined.
Second, the competiveness of Tokyo as an international financial center has not improved since the late 1990s. The number of foreign companies listed on the Tokyo Stock Exchange has fallen from 127 in 1991 to only 11 at present. In the latest Global Financial Centers Index published by Long Finance, Tokyo ranks sixth behind London; New York; Hong Kong, China; Singapore; and Shanghai.
Third, economic agents in Asian countries have had little incentive to shift from using the dollar to using the yen in international transactions because Asian currencies have been more stable against the dollar than against the yen, even after the 1997–98 Asian financial crisis.
Prospects for internationalization of the renminbi
Whether the renminbi succeeds in becoming a major international currency will depend largely on how quickly the same three conditions are met and to what extent. First, the PRC is overtaking the United States as the world’s largest trading nation and may become the world’s largest economy in the 2020s. Second, it may, however, take a longer time to build deep, liquid, and open capital markets. Third, should these two conditions be met, the chance that Asian currencies will shift from pegging loosely to the dollar to pegging closer to the renminbi, so that the Chinese currency will become more stable in effective terms, will also increase.
Therefore, building up the PRC’s capital markets would seem to be an important step toward realizing the internationalization of the renminbi. Deep, liquid, and open capital markets, however, presuppose the free mobility of capital. Economists generally agree that liberalization of a country’s capital account must not outpace the strengthening of its domestic financial sector and monitoring capability (the so-called sequencing problem).
The Asian financial crisis clearly showed the results if the wrong sequence is adopted. I share the concern of Professor Yu Yongding of the Chinese Academy of Social Sciences that by hastening to open its capital account in the name of promoting the use of the renminbi as an international currency, the PRC may be following the wrong sequence. (Professor Yu delivered a lecture on the internationalization of the renminbi at an ADBI Distinguished Speaker Seminar on 17 June 2011. Video available here.)
A preferable strategy is for the PRC to speed up domestic financial reform, liberalize interest rates and move to a more flexible exchange rate system first, before liberalizing the capital account. Together with the PRC‘s growing economic power, this should provide a solid foundation for the renminbi to become a major international currency on par with the U.S. dollar in the future.
This article is based on the paper delivered by C. H. Kwan at a session on the development of regional markets during the OECD-ADBI 12th Roundtable on Capital Market Reform in Asia on 7 February 2012.