As China’s yuan takes the first steps toward becoming a global reserve currency, Japan offers a lesson on how hard it is to rival the dollar’s supremacy.
The Japanese yen’s share of global reserves reached a record 8.5 percent in 1991 as the nation’s post-War industrial boom made its economy the world’s second-largest. But its economic decline soon resulted in its clout shrinking as the euro gained ground and the greenback re-asserted its dominance. While the yen is still ranked third for trading and fourth for payments, it now accounts for just 4 percent of world reserves, compared with the dollar’s 64 percent and the yuan’s 1 percent.
The yen’s failure to dent the U.S. currency’s primacy illustrates the precarious mix of policy, political will and prosperity needed for the yuan to come even close to dislodging the dollar. Like China, Japan struggled with the degree of openness needed to promote global use of its currency. By the time its markets became more accessible to foreigners, the bursting of its asset bubbles and consequent “lost decade” — coinciding with China’s dizzying rise — relegated the yen to its also-ran status as a reserve currency.
“The main lesson is that it is impossible to have a major reserve currency like the dollar or euro unless you are willing to sustain a high degree of financial market openness over a very long period of time,” said Arthur Kroeber, the Beijing-based founding partner and managing director at Gavekal Dragonomics, a research firm.
Like the yuan, the yen’s march toward liberalization was gradual and marked with ambivalence. Under the Bretton Woods system after World War II, the Japanese currency was fixed at 360 a dollar, before a trading band was introduced in 1959 to make it slightly more flexible. For three decades, all capital flows except those explicitly permitted were banned, making it easier for the government to achieve policy goals.
It wasn’t until 1998 that approval or notification requirements for financial transactions and outward direct investments were abolished. The push to internationalize the yen initially came from the U.S., which wanted greater global use to fuel appreciation and reduce Japan’s trade surplus with America.
China’s situation now isn’t dissimilar. Having thrived on an economic model of closed borders and accumulation of reserves for decades, its capital account is still closed, individuals’ foreign-exchange conversions are capped and inter-country money flows occur mainly through specific programs. Policy makers have tightened controls on outflows in the past year after the yuan’s August 2015 devaluation exacerbated depreciation pressures. The currency was little changed Friday at 6.6699 per dollar.
Lowering the hurdles to create a true freely traded currency might risk a flight of capital during times of weakness, a concept China doesn’t always seem comfortable with.
“Everyone wants this thing called ‘exorbitant privilege,’ but if you try to give it to them, they get furious and they tell you to stop,” said Michael Pettis, a finance professor at Peking University. “Countries like China that are running huge surpluses because of insufficient domestic demand — basically they are creating the role of the dollar as the dominant reserve currency.”
The term “exorbitant privilege,” coined by former French finance minister Valery Giscard D’Estaing in 1965, referred to the benefits the U.S. received for the dollar’s status.
Daniel McDowell, a Syracuse University political science assistant professor who studies international finance, made the point that the appeal of a nation’s sovereign debt market plays a key role in a currency’s internationalization. The yen never became a major reserve currency because its government bonds weren’t as attractive or as plentiful as the U.S., he said.
Overseas investors held 10 percent of Japan’s sovereign debt and treasury bills at end-June, central bank data show, compared with 41 percent for the U.S. at end-July, according to Bloomberg calculations. While the figure is around 1 percent for Chinese bonds, the nation has since February allowed all types of medium- to long-term investors to access the interbank market. Overseas funds increased their holdings of Chinese onshore bonds in June by 47.7 billion yuan to 764 billion yuan, according to latest available data from the People’s Bank of China.
China’s economic might could give it an advantage. It accounts for 18 percent of the world’s output on a purchasing power parity basis, more than Japan ever did, according to International Monetary Fund estimates going back to 1980. Despite making up just 1.1 percent of global reserves in a 2014 IMF survey, the yuan’s weight in the SDR basket from Saturday will be 10.9 percent, trumping the yen and sterling.
KKR & Co. and hedge fund manager Jim Chanos are among those who have compared China’s current economic slowdown with Japan’s woes after its real-estate and stock bubbles burst in the early 1990s. Asia’s largest economy is now coping with the slowest growth in more than two decades, while its housing market is looking overheated a year after a $5 trillion rout in its equity market.
“When the Japanese economy was booming, property and financial bubbles formed,” said Ha Jiming, Hong Kong-based chief investment strategist at Goldman Sachs Group Inc.’s private wealth unit in China. “Therefore, the yen didn’t become a very important international currency. That being said, China’s economy is bigger in size compared to Japan, so the renminbi may still have the potential to become a major currency. Eventually it will depend on how China can avoid a Japan-like boom-and-bust cycle.”