FRBSF Economic Letter
1996-30 | October 18, 1996
As awareness of Japan’s importance in the world economy has increased in recent years, interest in whether the dollar is likely to retain its pre-eminent role in world markets also has grown. Some observers have speculated that the yen is likely to be used more widely in international transactions, perhaps to the point of assuming some of the U.S. dollar’s role as a key international currency.
This Economic Letter reviews recent trends in the international use of the yen and finds that while such use has increased, there is no sign of a broad shift away from the dollar in global markets. Factors influencing the use of the yen in international markets and the yen’s prospects as an international currency are also discussed.
One important indicator of international yen use is the yen’s share in invoicing international trade transactions. Between 1970 and 1994, the share of the yen in invoicing Japan’s own exports rose sharply, from about 1 percent to nearly 40 percent, while the dollar’s share fell from 90 percent to around 50 percent. Though the change is quite dramatic, the yen’s share in Japan’s exports is still much lower than the share of the deutschemark in German exports, which was over 80 percent in the late 1980s. Other indicators also suggest that the use of the yen in invoicing remains limited. For example, although the share of yen invoicing in Japanese imports increased from less than 1 percent in 1970 to about 20 percent in 1994, this is still well below the deutschemark share in German imports, which has typically exceeded over 50 percent. The use of the yen in invoicing other countries’ trade is also small. For example, in 1993, yen-invoicing applied to only 2 percent of Germany’s trade.
Another indicator of international yen use is the yen’s share in international financial transactions. The evidence of growing yen use according to this criterion is mixed. On the one hand, there is little indication of a greater yen share in world foreign exchange markets. In 1995, the use of the dollar (involving either sales or purchases) as a percentage of global gross foreign exchange market turnover was 83 percent, down 7 percentage points from 1989, but still well above the 24 percent share of the yen, whose share had also declined (because the measure involves either sales or purchases, these shares sum to 200, rather than 100 percent). The share of the yen also appears to be relatively small in official foreign exchange reserves (9 percent in 1994).
On the other hand, the use of the yen in some types of international lending has increased. The yen accounted for about 16 percent of outstanding eurobond issues in 1995, up from less than 10 percent a decade earlier. This compares to a U.S. dollar share of 34 percent, and a deutschemark share of 12 percent in 1995. According to the World Bank, the share of the yen in international public and publicly guaranteed debt for non-Asian countries rose from an average of nearly 5 percent in the first half of the 1980s to an average of over 8 percent in 1990-1994. This is still below the 52 percent share of the dollar or the 13 percent share of the deutschemark. However, in Asian countries the yen share rose from 22 percent to 33 percent over the same period, putting it above the dollar share, which fell from 48 percent to 32 percent.
These figures suggest that while the international use of the yen has grown in some areas, the dollar is still the dominant currency in world financial markets. To understand why, it is useful to focus on two factors that have influenced the use of the yen and that should play a role in its further evolution as an international currency: (i) the stability of the yen’s purchasing power, and (ii) the extent to which other countries do business with Japanese residents by trading, borrowing, or lending.
People who use a currency for their international transactions typically require that its purchasing power be stable. By this criterion, the yen has become increasingly attractive. Japan’s average annual CPI inflation fell from 9.1 percent (third highest among the 7 major industrial countries) in 1970-1980 to 2.5 percent in 1980-1993 (the lowest rate among industrial countries). Japan also reduced inflation volatility (as measured by the standard deviation) from 5.3 percent to 2.0 percent. Low and less volatile inflation means that foreign firms trading with Japanese residents can invoice their transactions in Japanese yen without being penalized by sudden losses in yen purchasing power. Low inflation also makes yen-denominated assets attractive to investors and, by lowering the inflation premium, simultaneously creates an incentive to borrow in yen.
While low Japanese inflation makes the yen attractive, yen purchasing power also depends on the stability of the yen exchange rate. For example, a Hong Kong company whose import invoices are in yen and whose export invoices are in dollars may be adversely affected by an unexpected appreciation in the yen against the U.S. dollar. While hedging instruments exist, it may be simpler to arrange for imports to be invoiced in U.S. dollars rather than in yen to avoid the adverse effects of a yen appreciation. The company’s preference for the U.S. dollar may be reinforced by the fact that Hong Kong pegs its currency to the U.S. dollar (as do many other countries to varying degrees). In other words, the advantage of using the dollar in international transactions increases if the yen fluctuates more against the dollar than the local currency does. Thus, the volatility in the yen-dollar exchange rate may have limited the use of the yen in world financial markets.
Aside from dampening any long-run tendency to use yen, volatility in the yen-dollar exchange rate may induce fluctuations in the international use of the yen. For example, if borrowers in yen expect the currency to appreciate after depreciating, they may reduce their borrowing, resulting in a negative correlation between the yen-dollar exchange rate and borrowing in yen. In Figure 1, such a negative correlation is apparent between the end-of-year yen-dollar exchange rate and the annual share of international bond issues in yen (currency valuation effects are removed from the shares by converting yen values using the end of 1990 yen-dollar exchange rate in every year). The year-to-year fluctuations in shares are so large that they obscure the long-run trend, which appears to be rising.
Another factor influencing the international use of the yen is the extent to which foreigners do business with Japanese residents. Japanese international transactions have grown very rapidly in the past three decades, even if, as noted previously, this is not consistently reflected in a large share of the yen in international transactions. Between 1960 and 1994, Japan’s share in world trade rose from 3 percent to 8 percent. This is close to Germany’s share, and while it is still below the U.S. share of about 14 percent in 1994 (the same as in 1960) it is still significant. A number of explanations have been offered for why Japanese firms tend to do proportionately less international trade in yen than their counterparts do in their own currencies. On the import side, the bulk of Japanese imports is in primary commodities, such as oil or metals. These are typically priced in U.S. dollars in world markets. On the export side, since Japan’s largest market is the United States, Japanese exporters have an incentive to invoice in U.S. dollars so as not to surprise their buyers with frequent price fluctuations.
The increase in Japan’s share in international financing flows is even more striking than the growth in its international trade. According to OECD estimates, between 1982 and 1994 Japan’s stock of foreign assets grew at an annual rate of 22 percent, to a total of $2.4 trillion, the highest among industrial countries. Japan’s foreign liabilities also grew rapidly, to a total of $1.7 trillion (third after the U.S. and the U.K.).
Why has the dramatic increase in international financial transactions with Japanese residents not resulted in a corresponding surge in yen-denominated transactions? One explanation is that foreigners still find it more difficult to transact in yen than in U.S. dollars, because of certain characteristics of Japanese financial markets.
Although Japan has greatly liberalized access to its financial markets since the early 1980s, foreign banks find it costlier to obtain funds in the Japanese banking market than do Japanese banks, because their deposit base (the lowest-cost source of yen funds) is smaller. This tends to raise the cost of transacting in yen for non-Japanese entities, and may discourage the use of the yen internationally. Traditional restrictions on the currency exposure (net open positions) of Japanese banks also may have discouraged these banks from increasing their international transactions in yen. For example, Japanese banks borrowing U.S. dollars in international capital markets would lend in U.S. dollars to limit their currency exposure.
The depth and liquidity of Japan’s financial market also have increased considerably since the early 1980s. A variety of new financial instruments have been developed, and a repo market now exists in Japanese short-term treasury bills, in addition to the already well-established market in long-term government bonds. (In the repo market, a market participant sells a security and agrees to repurchase it after a period at a certain price.) Nevertheless, Japan’s financial markets still appear to be less deep and liquid than U.S. markets, especially at short maturities where much of the activity in international financial markets takes place. While investors can perform short-term transactions in the much deeper repo market for long-term Japanese government bonds, there is a general perception that the Japanese short-term treasury-bill market (which can provide a reference for private short-term financing activities) is not very liquid, in part because withholding taxes may discourage investors from holding the instrument (a significant proportion of Japanese T-bills appear to be held by Japanese banks who transact with the Bank of Japan and foreign central banks).
The Japanese T-bill market has grown rapidly, and in 1994 the value of Japanese T-bills outstanding was approximately $118 billion. However, the Japanese T-bill market is still small in relative terms. In 1994, the value of Japanese treasury bills outstanding was about 1/16 the value of Japanese government bonds, compared to 1/3 in the U.S. The value of Japanese T-bills outstanding was about 1/7th the size of the U.S. T-bills outstanding.
Some of the factors that have stimulated the international use of the yen may become less important in the future. In particular, there is no obvious tendency for Japan’s share in world trade to increase any further, as rapidly growing emerging market economies are likely to increase their own shares in world trade. Some East Asian economies, which historically trade proportionately more with Japan for geographic and historical reasons, may actually trade less with Japan as they diversify markets. For example, the share of Japan in South Korea’s trade fell from 24 percent in 1960 to 20 percent in 1994.
However, other factors will continue to encourage greater international use of the yen. Based on past experience, Japan is likely to continue to experience lower inflation than other countries, in spite of the challenges posed by recent rising budget deficits. Increasingly deep and more liquid Japanese financial markets also will enhance the attractiveness of the yen as an international currency.
Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. This publication is edited by Sam Zuckerman and Anita Todd. Permission to reprint must be obtained in writing.
Please send editorial comments and requests for reprint permission to
Attn: Research publications, MS 1140
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120