Taking on the Dollar: Japanese and Chinese Currency Internationalization in Comparative Perspective
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Taking on the Dollar: Japanese and Chinese Currency
Internationalization in Comparative Perspective∗
Daniel McDowell†
March 11, 2013
Abstract
Present conventional wisdom says the international currency system has entered a
period of change. The status of the dollar is on the decline and China’s currency, the
renminbi, is the top candidate to challenge the greenback for global preeminence. In the
1970s, a there was a similar refrain. Then, as today, the dollar was seen as a wounded
duck and the Japanese yen, issued by that era’s East Asian economic powerhouse, was
poised to take on an increasingly important international role. Yet, four decades later,
we now know that yen did not live up to these expectations. In this paper, I explore
why yen internationalization stalled and infer from this case the prospects for renminbi
internationalization today. Specifically, I compare the use of the yen and renminbi in
three important roles played by international currencies: official reserve assets and trade
invoicing and settlement. I compare these two cases of currency internationalization
along two dimensions: the structural and domestic conditions that contribute to or
inhibit the use of a currency outside of its national borders. A review of the evidence
finds that, structurally, the renminbi of today is in a stronger position than the yen
of the 1970s. However, the bag is mixed in terms of domestic conditions. In some
key areas, China’s domestic policy today lags far behind Japan’s of forty-years ago
and is seriously limiting the renminbi’s international prospects, especially as a reserve
currency.
∗
Paper prepared for the Workshop on Crisis and Change in the Global Monetary System, Ghent Institute
of International Studies, Ghent University, Belgium, March 20, 2013. Comments welcome.
†
Assistant Professor, Department of Political Science, Maxwell School, Syracuse University, Syracuse, NY
13244. E-mail:dmcdowel@maxwell.syr.edu Web:danielmcdowell.net1 Introduction
Pick up any article on the international monetary system written in the last five years and
you are likely to find a common refrain: The dollar’s halcylon days perched unchallenged
atop the global currency hierarchy are over. Partially an unavoidable result of America’s
relative economic decline and partially a consequence of American financial mismanagement
as evidenced by the Global Financial Crisis of 2008-2009, there is a growing international
consensus that a multipolar international currency system should–and will–soon supplant the
unipolar era of the dollar. In his most recent book, economic historian Barry Eichengreen
echoes this sentiment stating, “The world for which we need to prepare is thus one in which
several international currencies coexist”(Eichengreen 2011, 8). Similarly, Nouriel Roubini has
posited that “we may now be entering the Asian century, dominated by a rising China and its
currency” (Roubini 2009). Evidenced by these two quotes, as pronouncements of the dollar’s
decline have become more commonplace, assertions that China’s currency–the renminbi (or
yuan)–is poised to become the next global currency are becoming equally prevalent. The
bright future for the renminbi is predicated on China’s position as the world’s second largest
economy, its recent ascention to becoming the world’s top trading state, and Beijing’s decision
to promote the currency’s international footprint since the middle of the last decade.
Predicting seizmic shifts in the international currency system is not just a recent pastime,
however. The tradition goes back at least three, if not four, decades. Just like the scholars of
today, the prognosticators of the 1970s and 1980s witnessed a declining American economy.
At that time, however, American decline was relative to upstarts Germany and Japan which
promised faster long-run growth in both production and trade. The world economy was
becoming more “polycentric” and naturally the international currency system was believed
to be heading in the same direction (Bernstein 1982; Kindleberger 1985; Horii 1986). As
one scholar of the subject put it, “the idea of moving away from the dollar as the sole
pillar of the [monetary] system is broadly accepted” (Morse 1979, 362). Like China today,
1Japan of the early 1970s had grown to become the world’s second largest economy and
was an East Asian export powerhouse running a large current account surplus with the
United States. Meanwhile, the American economy and the dollar both appeard to be on the
decline. The yen seemed like an obvious candidate (along with the German deutschemark)
to take on a substantial, and rightful, role in the new “polycentric” global monetary system.
Beginning in the 1970s and continuing through the next decade, the yen’s international
presence across a range of measures increased. However, by the 1990s, it was evident that
yen internationalization had stalled and the dollar had more than reaffirmed its preeminent
position as top global currency.
Why did yen internationalization not live up to its full potential? Was its limited rise the
result of structural economic factors outside of Japan’s control? Or, was it the consequence
of Japanese policy? This paper compares the first two decades yen internationalization with
the renminbi’s recent debut on the world stage in order to better inform our understanding
of the renminbi’s prospects as an international currency. Specifically, I compare the use of
the yen and renminbi in three important roles played by international currencies: official
reserve assets and trade invoicing and settlement. I compare these two cases of currency
internationalization along two dimensions: the structural and domestic conditions that con-
tribute to or inhibit the use of a currency outside of its national borders. A careful review
of the evidence finds that, structurally, the renminbi of today is in a stronger position than
the yen of the 1970s. However, the bag is mixed in terms of domestic conditions. In some
key areas, China’s domestic policy today lags far behind Japan’s of forty-years ago and is
seriously limiting the renminbi’s international prospects, especially as a reserve currency.
This paper will proceed as follows. First, I define and briefly describe what I mean by
currency internationalization. Next, I describe the research design I will employ and clarify
my framework for comparison, defining what I mean by structural and domestic conditions.
This is followed by an empirical comparison of the two cases, first focusing on the reserve
currency role followed by trade invoicing and settlement. Finally, I sum up my findings and
2offer some closing thoughts.
2 Currency Internationalization
Currency internationalization, put simply, is the process by which a local currency becomes
increasingly used outside of its national borders. In lieu of a single world currency, the
global economy needs at least one internationalized currency to function efficiently; otherwise,
countries would be forced to barter with one another to settle any cross-border transactions
(Cohen 2012, 2). International money, like local currency, must serve three roles: a medium
of exchange, a unit of account, and a store of value. Additionally, international money must
prove useful to both private market actors as well as foreign governments. Based on these
parameters, the accepted typology for the roles of an international currency is presented in
Table 1 (Kenen 1983; Chinn and Frankel 2005; Cohen 2011a).1
Table 1: The Roles of International Currency
Medium of Exchange Unit of Account Store of Value
Private trade settlement, foreign invoicing trade and finan- investment, currency
exchange trading cial transactions substitution
Official vehicle for foreign ex- anchor for pegging local reserve currency
change intervention currency
The vast majority of local currencies do not see any international use. However, there
are a select few currencies that are widely used outside of their home country. Yet, even
among these monies, there is variation. Cohen (1998, 2011a) has proposed that there is a
1
An alternative way to typologize the private use of international currencies is to divide up its use into
three general categories. The first is in the area of international trade where a currency may be used for
trade pricing, invoicing, and settlement. A second area is in international debt markets where a currency
may be used for financing and investment purposes. The final international use of a currency in foreign
exchange markets as a payment vehicle (Hongbin and Junwei 2009, 3).
3hierarchy of international currencies which he calls the “currency pyramid” which is “narrow
at the peak, where the strongest currencies dominate, and increasingly broad below, reflecting
varying degrees of competitive inferiority” (Cohen 2011b, 9). Appropriately, at the top of the
pyramid is the “top currency” which is simultaneously the dominant international medium of
exchange, a globally accepted exchange-rate anchor, and the most popular reserve currency.
As Cohen puts it, the top currency dominates...most if not all types of cross-border purposes”
and has more or less universal [popularity], not limited to any particular geographic region”
(Cohen 1998, 116). Cohen rightly maintains that presently, the dollar remains–as it has
for the better part of seventy years–the world’s dominant global currency and is therefore
the world’s only true top currency.2 However, the dollar has not always occupied the apex
positition on the pyramid and is not likely to remain their forever. Predicting when the
dollar will inevitably fall from its perch has been an occasional pasttime for scholars of the
global currency system going back decades. Take, for instance, this “pronunciamento” from
Charles Kindleberger: “The dollar will end up on history’s ashheap, along with sterling, the
guilder, florin, ducat, and if you choose to go way back, the Levantine bezant” (Kindleberger
1985, 308).
Of course, if and when the dollar does lose its grip on the top currency slot, it will not
purely be a function of American economic decline and/or currency mismanagement. Rather,
its occurrance will also reflect the existence of a sufficiently attractive alternative to the
greenback. In other words, the dollar is more likely to be pushed from its current position, as
opposed to tripping and falling all on its own. Consequently, when conversations regarding
the dollar’s decline as an international currency periodically heat up, a necessary part of the
discussion must attempt to answer the question: “if not the dollar, then what?” Presently, as
I indicated in the introduction, the popular answer to that question is the Chinese renminbi.
Three decades ago, a popular answer was the Japanese yen.
Yet, there are considerable hurdles in the renminbi’s path to internationalization, just as
2
For a detailed description of Cohen’s Currency Pyramid and all of its levels, see Cohen 1998, 115-118.
4there were to the yen’s path in more than thirty years ago. In a number of ways, China
today resembles Japan of the 1970s. Then, Japan was a rapidly growing East Asian export-
led economy second only to the U.S. in economic size (and gaining) yet it possessed a national
currency that had almost no international role despite its dominant economic position in East
Asia and the global economy as a whole. Of course, we now know that the Japanese yen
would eventually come to satisfy these conditions at a basic level and emerge as an important
international currency. For instance, Cohen places the Japanese yen in the second-best tier of
his currency pyramid, what he calls “patrician” currencies which he defines as “moneys whose
use for various cross-border purposes, while substantial, is something less than dominant and
whose popularity, while widespread, is something less than global” (2011a, 13-14).3 Despite
the yen’s achievement, the currency’s modest international role today is something of an
underachievement given its once loftly potential. What, if anything, then can we learn about
the renminbi’s prospects as an international currency from the yen’s experience decades ago?
Below, I discuss the research design for this paper, explaining how and what I will compare
across the two cases as well as why I have chosen this approach.
3 Research Design
In the simplest sense, my research design for this paper is a standard comparative case study.
Yet, I must admit that in reality, it is not quite this simple. More specifically, this project
entails the comparison of a set of conditions that contributed to one event (the limited rise
of the Japanese yen as an international currency) with a set of conditions that I suspect
will contribute to another event that has yet to take place (the rise of the renminbi as an
international currency to heights unknown). Indeed, to be fair, the latter may in fact never
take place at all. Thus, the decision to compare the conditions that contributed to one
event with those that (may) contribute to one (as yet) non-event precludes this study from
3
Cohen places the euro in this category as well, though he rightly ranks this above the yen.
5attempting to conduct “normal science” in the truest sense. Neither am I claiming to be
engaging in forecasting the likelihood that the renminbi will one day truly challenge the
dollar as “top currency”. Rather, the goals of this project are quite modest. In a limited
sense I am engaging in causal inference if by this we mean trying to determine what we do not
know from what we do know. However, this only applies to the Japanese case. With respect
to the case of the yen’s rise, I do hope to identify the conditions (or independent variables)
that both contributed to and hindered the currency’s internationalization (the dependent
variable). In other words, I hope to explain what caused the yen’s rise to be so modest.
However, since the outcome of the second case–the renminbi’s rise–is still to be determined,
there is no variation to exploit on the dependent variable. Thus, the comparison will be
entierly on the “right hand side” of the equation. That is, I am seeking to determine if the
conditions which contributed to or hindered the yen’s international use (in various roles) in
the 1970s and early 1980s are absent or present today in relation to the Chinese renminbi.
Given the noted similarities between the two cases, I am making the following limited claim:
If the conditions that will likely determine the extent of the renminbi’s internationalization
are more favorable than the conditions facing the yen in the 1970s and early 1980s, then we
have greater reason to believe the renminbi’s rise will surpass the yen’s; conversely, if these
conditions are equal to or less favorable than those facing the yen, then we have greater
reason to believe the renminbi’s rise will mirror–or even lag behind–the yen’s.
3.1 A Framework for Comparison
The conventional wisdom says that the following three broad conditions must be satisfied
for a national currency to become widely used as an international currency in all facets:
1. The issuing country has a substantial international economic presence;
2. International confidence in the stability of the currency’s value; this implies (1) price
6stability (low inflation with little fluctuation); (2) political stability in the issuing
country;
3. The currency is convenient to use for international transactions; this presupposes that
the issuing country has stable financial markets where a broad range of instruments are
freely traded in large volume. That is, financial markets must be stable, wide, liquid,
open, and deep.4
To make the comparison of the two cases more structured, I break the conditions listed
above into into two categories. The first of these is what I will refer to as structural con-
ditions. Generally speaking, structural conditions comport with the first condition listed
above. Structural conditions change relatively slowly and are therefore more stable over
time, making it easier to predict what they may look like in the short- and medium-term.
Furthermore, structural conditions are not entirely under the control of the country issuing
the aspiring international currency as they are relational conditions; that is, the values they
take on are dependent on internal–as well as external–factors. Across the two cases I will
compare the following three structural conditions that affect currency internationalization.
The first two are components of a country’s international economic presence: (1) the relative
size of the national economy and (2) the national share of global trade. The third structural
condition I consider, not directly related to the conditions listed above, is (3) international
confidence in the status quo top currency. As I have already discussed, any consideration of
the yen or renminbi’s hopes as top international currencies must also consider the health of
the current title holder.
The second group of factors that contributes to a currency’s likelihood of “going global”
are domestic conditions which comport to the second and third conditions listed above.
Unlike structural conditions, domestic conditions have the potential to change more quickly
and in less predictable ways since they are largely contingent on policy choices. Domestic
4
Garber (1996) says on this point, “In particular, [the issuing country] should have liquid, short-term
markets that allow foreigners to move funds in readily, briefly park them, and move them out” (2).
7conditions are determined by internal political and economic developments and therefore
the values they take on are not so dependent on external factors. Examples of domestic
conditions contributing to currency internationalization include the openness and maturity
of the issuing country’s financial markets, the stability of its currency, and the stability of
the its political system. Table 2 summarizes both sets of conditions.
Table 2: Conditions Contributing to Currency Internationalization
Structural Domestic
relative size of economy financial market openness and
maturity
national share of global trade currency stability
confidence in top currency political stability
As a brief aside, I should note that I do not include the convenience and liquidity of a
currency in foreign exchange markets as a structural condition in this paper. To some, this
may seem a significant omission. My justification for this choice, however, is based on the fact
that I carefully consider the openness and maturity of an issuing country’s financial markets.
Since this is, I would argue, the most important factor determining a money’s convenience
and liquidity in foreign exchange markets (especially in these cases) it is subsumed in the
comparison of domestic conditions.
While a fully internationalized currency should perform all six roles outlined in Table 1 above,
my analysis here will not compare the yen and renminbi on all of these areas. I compare the
conditions that contributed to the yen’s expanded international role in the 1970s and 1980s
with the internationalization of the renminbi today in three key roles: (1) use as an official
reserve currency and (2) international trade invoicing and (3) settlement (for organizational
purposes, I fold the trade invoicing and settlement roles into the same section below). The
decision to limit the focus of the paper to these three roles was based on several reasons.
First, a paper that might compare the cases across all six roles might quickly turn into a small
8book. Second, I was able to locate better data–necessary for comparison–for the reserve and
trade roles. Third, each of the three roles considered represents a different function of money,
making the paper comprehensive in at least this sense.5 Finally, and most important, a key
condition facilitating a currency’s use in trade and especially as a reserve asset is its use as an
investment currency at the private level. Consequently, while I do not compare these cases on
this dimension explicitly, it is implicit throughout the paper. In sum, the research design here
will compare the two cases on two dimensions (structural and domestic) in three roles (reserve
role and trade role). After a brief review of the broader historical context surrounding the
two periods under consideration, the remaining comparative empirical portion of the paper
is organized around these two roles.
4 Reserve Currency
Of all the international roles a currency may play, reserve status can properly be considered
the “granddaddy of them all”. None of the other roles bestow as much social status or
monetary power upon a nation than issuing an important reserve currency.6 Consequently,
from a political-economic perspective, the reserve role tends to get the most attention. A
number of studies have pointed out that issuing the top reserve currency brings with it not
only a special status, but also power. Cohen (2006) argues that the U.S. possesses “power
as autonomy”7 by virtue of the dollar’s reserve role. Most specifically, the U.S. has the
power to delay adjustment even in the face of persistent current account and budget deficits.
Kirshner (2008) spells out the costs to U.S. power were the dollar to lose its top slot as
a reserve currency including a reduced global political influence and the need to reduce its
5
medium of exchange (trade settlement); unit of account (trade invoicing); and store of value (reserve
currency).
6
However, it is also true that issuing the top reserve currency comes with some costs as well. Garber
(1996, 4) points out that such a position increases the vulnerability of the currency to major demand shifts,
meaning the money faces an additional source of instability.
7
Power as autonomy is different from power as influence, Cohen explains. While the latter is how we
conceive of power in the traditional sense, the former implies the ability to not be influenced by others.
9global military presence. Consequently, countries with potential international currencies may
have the strongest economic and geopolitical motivations for eroding the dollar’s dominance
in this role. Moreover, when signs appear that such moves may be taking place, much
attention is given to the prospects of change.
Speculation about major shifts in the international currency system began almost immedi-
ately following the Nixon Shock of 1971. By the end of the decade, amidst what seemed to
be near permanent American economic decline, trade deficits, and inflation, questions sur-
rounding the dollar’s position as top reserve currency were commonplace. One Businessweek
article quipped, “The role of the dollar as the world’s major reserve currency is beginning
to be eroded by its weakness and the inability of the Carter Administration to check its
fall. Investors...are hurrying to move cash into marks, Swiss francs, and Japanese yen. For-
eign central banks are doing the same” (Businessweek 1978). The following year, the same
publication reported that governments were “flocking” to purchase yen-denominated assets
(Businessweek 1979). By the early-1980s, there seemed to be a consensus among scholars as
well as central bankers that the world was (and perhaps should be) moving toward a multi-
currency reserve system (The Banker, 1980). Dini (1984) sums up the developments in the
first decade following the denouement of the Bretton Woods monetary order as follows: “In
the first years of floating, with confidence in the dollar faltering as a result of accelerating
inflation and expansionary policies in the United States, the demand for Deutsche Mark,
Japanese yen and Swiss francs by official reserve holders increased substantially, fostering
the development of a multicurrency reserve system.”8
Yet, as undeniable a fact as reserve diversification throughout the 1970s and 1980s was,
the shift was ultimately more marginal than revolutionary. Indeed the dollar’s share of
international reserves actually increased through most of the 1970s and ranged from 70 to 80
percent until the mid-1980s. For its part, the growth of the yen as an international reserve
8
See Horii (1986) for a compelling case that reserve diversification did not occur at the level many scholars
at the time were claiming.
10asset moved quite slowly in its first decade in this role. While the yen first registered as a
reserve currency in 1972, it’s share was only one-tenth of one percent. By 1983 the yen’s
share had increased to about 5 percent of world reserves, but it soon peaked in 1991 at just
8.5 percent and has basically been in perpetual decline since. Figure 1 plots the dollar’s
share of world reserves alongside the yen’s for the years 1970 to 1991.9
Figure 1: Share of International Reserves
Today, discussions about the dollar’s position as top reserve currency and the potential for
a substantial role for the renminbi sound similar to the doom and gloom surrounding the
dollar when the yen was making its debut on this stage. Today, scholars are pointing to
the Federal Reserve’s expansionary (and some say inflationary) policies–best embodied in
three rounds of so-called “quantitative easing”–as the reason for the dollar’s unavoidable
decline. A recent report from J.P. Morgan Chase, examining the dollar’s future, notes that
investors have begun “to question how much longer the dollar’s status as the world’s de
9
Data for years 1970, 1972 from Hori (1986); data for years 1973-2009 from Lee (2010); data for 2010,
author’s calculations from IMF COFER database.
11facto reserve currency will remain unchallenged” (J.P. Morgan 2009, 1). As quoted in the
introduction, Barry Eichengreen, arguably the prominent economic historian today when it
comes to monetary issues, has been a leading voice touting that the future holds a multipolar
reserve system. Elsewhere, Eichengreen has argued that in the decades to come, the U.S.
will likely share the burden of providing “safe and liquid assets” to the global economy with
Europe and China (Eichengreen 2012). And, the most pessimistic prediction of all for the
dollar (yet equally optimistic for the renminbi) comes from a study by Subramanian (2011)
that argues the the renminbi is poised to dethrone the dollar as the world’s preeminent
reserve currency “by the end of this decade or early in the next one” (16).
Speculation and prediction aside for the moment, the renminbi only first made its appear-
ance as a reserve asset in late-2010. Presently, the renminbi’s status as a global reserve
currency resembles the yen’s in 1972. While some central banks have shifted a portion of
their reserves into Chinese “redbacks”, the numbers remain very small. According to pub-
lished news accounts, I have counted a total of eight countries that have publicly announced
official investments in renminbi-denominated assets. Table 3 lists these countries, as well
as when they aded renminbi-denominated assets to their investments and how much they
invested (where available).10 At least six additional countries have suggested they are or
would be interested in adding remninbi investments in the future.11 In total, as of October
2012, global renminbi reserves range in value from a low-end estimate of $15 billion to a
high-end estimate of $20 billion based on my calculations. With total international foreign
exchange reserve assets valued at $12 trillion, renminbi-denominated securities make up–at
most–about 0.17 percent of global reserves.
So, is the renminbi’s future likely to live up to some of the lofty expectations surrounding
it today? Or, is it more likely to mirror the yen’s muted rise? Below I compare the two
10
List from various media reports confirming official investment in renminbi-denominated assets; some
totals reported, others estimated by author.
11
Countries include, in order of indicating interest: Kazakhstan (May 2011), Venezuela, Russia (September
2011), Saudi Arabia (May 2012), Taiwan (September 2012), and Australia (September 2012).
12Table 3: Official Reserve Assets in RMB by Country
Country Date of initial investment Total investment
Malaysia September 2010 Undisclosed
Chile September 2011 1.68% of reserves as of September 2012
(About $688 mn)
Nigeria September 2011 Undisclosed, though central bank governor
set goal of 5% - 10% of total reserves (re-
portedly as high as $500 mn)
Thailand November 2011 0.5% as of June 2012 (about $900 mn)
Japan December 2011 $10.3 bn as of March 2012
Korea July 2012 Roughly 1% of reserves (about $3 bn)
Indonesia July 2012 Undisclosed
Tanzania August 2012 Undisclosed
cases in terms of both structural and domestic conditions contributing to (or inhibiting) the
currencies’ internationalization as reserve currencies.
4.1 Structural Conditions
The first structural condition related to a currency’s “fitness” to serve as a reserve currency
is the relative economic size of the issuing country. Historically, the international use of a
currency has typically corresponded with the rise and fall of a country’s overall economic
power (Bergsten 1975; Eichengreen 1994). In the mid-1970s, when foreign central banks first
began investing substantial sums of money into yen-denominated assets, the size of Japan’s
economy was second only to America’s as its share of global GDP had grown to roughly
10 percent, rising to about 12.5 percent by the late 1970s. At that time, the U.S. share of
global GDP had fallen by more than 10 percent over the decade to under 30 percent as the
domestic economy was mired in stagflation. Still, by 1980, the U.S. share of world output
led Japan by more than 16 percent. After a U.S. economic resurgence in the first half of the
131980s, Japan again began to catch up to the U.S. in terms of economic size, closing the gap
between itself and the U.S. to around 11 percent by 1988 and then a mere 8 percent in 1994
when the American economy only comprised one-quarter of world output (see Figure 2).12
Adding to the similarities between Japan of that era and China of today, a look at the
current distribution of GDP across countries reveals that as of 2011 (the year following the
renminbi’s debut as a reserve currency) China’s economy represented just over 10 percent
of global output that year–almost identical to Japan’s position in 1973 (the year following
the yen’s debut).While this is no surprise to anyone who has paid attention to the news in
the past several years, China has more than doubled its share of world GDP since 2005. In
comparison, the American share fell below 25 percent for the first time in the period under
investigation here in 2008 and has continued this downward trend since. In 2011, the most
recent data avaialable, the American share of global output led China’s by about 11 percent
(see Figure 3).13 Compare this to a more than 20 percent lead by the U.S. relative to Japan
in 1973 and, at least at the stage of initial introduction of a new reserve currency, China’s
enjoys a better structural position in terms of economic size relative to the U.S. Of course,
even though structural factors tend to change slowly, there is not way to know with certainty
if this trend will continue. Not many would have predicted the U.S. economy to rebound so
strongly after the morass of the late-1970s; Simiarly, China’s days of double-digit economic
growth may be over. Yet, presently, we live in an era where emerging market economies like
China, Brazil, India, and others are consistently posting growth rates two to three times
larger than the advanced industrial economies. In this context, it seems unlikely that U.S.
share of world GDP will ever consistently return to levels above 25 or 30 percent.
A second structural condition found to be associated with reserve currency status is an
economy’s share of world trade (Subramanian 2011). Japan’s model for growth in the decades
following World War II resembes China’s model of the last decade as in both cases the
12
Author’s calculations based on data from World Bank, World Development Indicators databank available
at: http://databank.worldbank.org/ddp/home.do?Step=1&id=4
13
See previous footnote.
14Figure 2: Share of Total World GDP, 1970-1990
Figure 3: Share of Total World GDP, 2000-2011
15state implemented industrial policy intended to promote both industrialization and growth
through exports. Moreover, in the late-1970s and early-1980s, Japan faced charges from
the U.S. that it kept the yen artifically undervalued to give its exports a competitive boost
resulting in a large and growing bilateral current account surplus for Japan. China today, of
course, is on the receiving end the exact same charges. In short, both Japan of the past and
China of today are examples of powerhouse East Asian export economies. So, how do these
cases compare in terms of share of world trade?
At the time of the yen’s introduction as a reserve currency Japan’s share of global trade
equalled roughly 7 percent. This was a bit more than half of the U.S. position which hov-
ered around 13 percent in 1973-74. Japan’s share of world trade stayed relatively stagnant
throughout that decade but began to pick up in the 1980s, rising to about 9 percent in 1984.
However, America’s share was also picking up at this time; in fact, the gap between the two
countries had acttually widened by the middle of the decade (see Figure 4).14 If we compare
this to China’s current status in the global tradeing system, it is clear that the latter main-
tains a considerably stronger position at the starting line. The growth in China’s share of
world trade over the last 10 years is even more impressive than its overall economic growth.
Today, as the renminbi has just started appearing in official reserves, China’s share of world
trade in 2011 was above 11 percent and in a statistical dead heat with the share captured by
the U.S., closing a 15 percent gap in just a dozen years (see Figure 5).15 The U.S. Commerce
Department reported in February 2013 that, based on their data, China officially surpassed
the U.S. as the world’s largest trading nation in 2012. There is no way of knowing exactly
how things will trend over the coming decade, but the general point here is that the renminbi
again enjoys a structural advantage over the yen of three decades ago.
The third structural condition I consider here is the international confidence in the status quo
top currency: the dollar. Official reserve assets perform the“store of value”function of money.
14
Author’s calculations based on data from U.N. Comtrade database, available at: http://comtrade.un.
org/db/
15
See previous footnote
16Figure 4: Share of Total World Trade, 1970-1990
Figure 5: Share of Total World Trade, 2000-2011
17Therefore, in the most basic sense, confidence in a reserve currency reflects a collective belief
on the part of central banks that assets denominated in a particular currency are not only
going to hold their value, but also that over the long-term, they will not suffer a significant
opportunity cost by not investing in assets denominated in alternative reserve currencies.
All else equal, periods of depreciation should decrease international confidence in the dollar
as a reserve asset whereas periods of stability or even some appreciation should maintain or
increase confidence in the currency.16
Despite the fact that the dollar’s value plummeted relative to gold in the initial years follow-
ing the closing of the gold window in 1971 (Kirshner 2008, 423) the dollar remained relatively
stable from 1973 until the end of that decade in relation to a basket of currencies of its major
trading parners. It was not until late in the 1970s when a weakening U.S. economy accom-
panied by high inflation caused a sustained weakening of the dollar which unquestionably
decreased international confidence in the greenback as a reserve currency (and in fact directly
led to predictions of a shift towards a multi-currency reserve system cited earlier). However,
the weak dollar only lingered for a few years and by the early 1980s, the trend reversed
with the dollar strengthening considerably for four years (see figure 6).17 In fact, the dollar
became so strong that American exports were suffering and the U.S. current account deficit
was growing prompting the Reagan administration to push for the Yen-Dollar agreement
in 1984 (discussed more below) and the Plaza Accords the following year. The result was
a concerted effort by the Federal Reserve, Bank of Japan, and Bundesbank to collectively
weaken the dollar and strengthen yen and deutschemark. Meanwhile, against the dollar,
the yen exchange rate was somewhat unstable until the yen-dollar agreement encountering
periods of sustained depreciation (1973-1976; 1978-1980; 1981-1983) as well as substantial
16
Of course, prolonged appreciation to the point where the currency becomes substantially overvalued
poses its own problems since governments worry that they are buying a currency when its stock is too high
and depreciation is almost certainly in the cards one day.
17
Dollar nominal major currencies index data available at http://www.federalreserve.gov/releases/
h10/summary/indexn_m.htm; yen-dollar exchange rate data available at: http://research.stlouisfed.
org/fred2/data/EXJPUS.txt. Webb (1991, 330) notes that official demand for dollar assets did not decline
despite the fact that the dollar was obviously overvalued.
18strengthening (1976-1978; 1980-1981).
Presently, the dollar is in the midst of a persistent downward trend since early 2002. As of
January 2013, the dollar sat at only 6 percent above its all-time low (reached in August 2011)
and was a full 23 percent below its average rate dating back to January 1973. Coupled with
the growing U.S. national debt, persistent current account deficits, and a Federal Reserve
focused on stimulating growth, it is perhaps not a surprise that questions surrounding the
dollar’s continued role as the top reserve currency are becoming more and more common.
By comparison, the renminbi–which of course is carefully managed by the People’s Bank
of China (PBC) and is largely indexed to the dollar–has gradually appreciated over this
period and, in the long-run, most expect that the redback will continue to strengthen (see
Figure 7).18 While comparing the dollar’s exchange rate across these periods is only one
factor that contributes to international confidence in a reserve currency, on this metric,
again, the renminbi seems to be debuting under more favorable conditions for an upstart
challenger.
4.2 Domestic Conditions
The first–and frankly most important–domestic condition that affects a currency’s ability to
function as a global reserve currency is the openness and maturity of the issuing country’s
domestic financial market. By openness I of course mean a circumstance where it not only
possible, but also easy, for foreign investors to buy and sell assets denominated in the partic-
ular currency within the territory of the issuing country with few restrictions. By maturity
I of course mean that there are a diverse array of financial products with varying maturities
that investors may purchase and trade efficiently with few restrictions.
With respect to financial market openness, a worthwhile place to begin is comparing Japan’s
18
Dollar nominal major currencies index data available at http://www.federalreserve.gov/releases/
h10/summary/indexn_m.htm; renminbi-dollar exchange rate data available at: http://research.
stlouisfed.org/fred2/graph/?s[1][id]=EXCHUS
19Figure 6: USD and JPY Exchange Rates, 1970-1990
Figure 7: USD and RMB Exchange Rates, 2000-2012
20de jure capital account openness in the early years of Yen internationalization with that of
China today. The most widely used measure of capital account openness in the de jure sense
is the Chinn-Ito Index which bases its measure of openness on reported restrictions on inter-
national financial transactions to the IMF’s Annual Report on Exchange Arrangemetns and
Exchange Restrictions. A higher number represents a more liberal capital account (topping
off at about 2.5 indicating a fully open system, at least on paper) while a lower number
represents a less liberal one.19
Looking first at Japan, Figure 8 plots the country’s Chinn-Ito score beginning in 1970 through
1990. In order to put this in some context, I also include the average score for all reporting
countries for each year as well. For the entire period, Japan’s capital account was more
open than the global average. After an initial burst of liberalization in the early 1970s
when yen-denominated assets began showing up in official reserves, efforts appear to plateau
until the last two years of the decade. This comports with what Horne (1985) has said,
noting that “throughout the 1970s, the [Ministry of Finance] imposed controls on short-term
[capital] outflows and inflows” (150). By the start of the next decade, however, Japan once
again embarked on a second period of liberalization until–in 1983–they achieve the highest
possible score on the index (which they have sustained ever since). By comparison, from 2000
to 2010, China’s score has stayed flat consistently well below (and falling further behind) the
global average as seen in Figure 9. Thus, in terms of de jure capital account openness, the
yen’s made its reserve currency debut amidst more favorable conditions than the renminbi
has today.
Yet, measures of official capital account openness do not capture all nuances of a country’s
financial openness. As Prasad and Ye (2012) have pointed out, “there are many other subtle
or limited changes that are often not captured by standard de jure indices” (5). Additionally,
measures of openness do not say much about the maturity of a domestic financial market,
which also bears on the prospects of a national currency functioning as a store of value at
19
The Chinn-Ito index is available for download at: http://web.pdx.edu/~ito/Chinn-Ito_website.htm
21Figure 8: Capital Account Openness (Chinn-Ito), 1970-1990
Figure 9: Capital Account Openness (Chinn-Ito), 2000-2010
22the official level. In order see the whole picture, we need to take a closer look at the specific
policy measures taken in each case designed to promote the yen and renminbi as reserve
assets.
In the 1970s, Japanese authorities were not keen on seeing the yen play a substantial interna-
tional role, despite the fact that their economy was casting an increasingly large shadow on
the global stage. This lack of enthusiasm translated into policies that intentionally shortened
the leash on the yen outside of Japan’s borders. As one scholar put it, government policy
on yen internationalization was “on the discourging side of neutral [as]...monetary author-
ities...were concerned that extensive foreign holdings of their currency would reduce their
degree of control over the money supply, and would increase the variability of the exchange
rate” (Frankel 1984, 34). Especially concerning was the prospect that a shift in the global
composition of reserves away from dollars into yen would cause the yen to strengthen and
reduce the competitiveness of Japanese exports (Grimes 2003a, 179-180). Thus, in 1971
authorities imposed restrictions on acquisition of short-term government securities by non-
residents. In spite of these restrictions, London became an off-shore hub for yen-denominated
securities. Corporations could, for instance, issue yen-denominated bonds in the so-called
“euroyen” market (theoretically) free of Tokyo’s restrictions. However, because the largest
investor market for such euroyen bonds were Japanese residents, the market was thus still
constrained (Frankel 1984, 41).
A short three years later, Japan eliminated its 1971 restrictions on non-residents making it
possible for foreign investors, including governmetns, to purchase government backed yen
securities (Aramaki 2006). By the end of the decade, Japan initiated efforts to develop and
modernize its money markets. In May 1979, Japan’s Ministry of Finance (MOF) approved
the sale of yen-denominated certificates of deposit (CDs) to non-residents. In a short six
months, $5 billion had been invested in Japanese money markets by non-residents. Most
importantly for the yen’s reserve currency status, official investors were the main driver
of this market seeking out higher yields on short-term investments and–given its troubles
23at that time–diversification of their investments away from the dollar (Businessweek 1979).
Arguably, the most important step taken by Japanese authorities came in 1980 when the
Foreign Exchange and Controls law was amended and the yen became fully convertible (Ito,
Koibuchi, Sato, and Shimizu 2010). In short, these reforms meant that unrestricted capital
flows in and out of Japan were “to be the rule rather than the exception” (Cargill 1985,
123). According to Freeman (1984) it was also around 1980 that Japanese authorities began
actively supporting the diversification of foreign reserves into yen-denominated assets. He
notes that Japanese authorities used several measures to promote official interest in the yen
by “freeing the interest rate on official yen deposits in Japan and encouraging purchases–
particularly by OPEC authorities–of yen-denominated assets” (Freemand 1984, 14).20
Despite these significant reforms, The U.S.–Japan’s most important ally and economic partner–
wanted more. In the early-1980s, Washington felt strongly that as an international currency,
the yen was punching far below its true weight class. Specifically, the U.S. wanted to see
Japan further liberalize its capital account and allow foreigners, including central banks,
to more freely invest in yen products–both on-shore and off-shore. This would affect the
yen to appreciate against the dollar and, in turn, help reduce American current account
imbalances with Japan. So, in 1983, the U.S. and Japan initiated what became known as
the “Yen/Dollar Working Group” which was set up to explore reforms that could address
U.S.-Japanese imbalances through further internationalizing the yen. In the end, the bilat-
eral Working Group concluded that it was “fitting for the yen to play a role in international
financial transactions that reflects Japan’s importance as a great trading and financial world
power” (Japanese Ministry of Finance and U.S. Department of the Treasury Working Group
1984, 25). According to some scholars, by the mid-1980s, Japanese policymakers had de-
veloped a “more relaxed attitude” to the idea of foreign-held yen-denominated assets. This
new attitude manifested itself in the further development of the on-shore yen bond market
20
Eken (1984) notes that by the mid-1980s, the yen’s importance as a reserve currency was greater among
developing countries that among their industrial peers. Similar to Freeman, Eken says this “partly reflects
the attempts made by members of [OPEC] to diversify their foreign exchange holdings” (Eken 1984, 531).
24known also as “samurai bonds” (Horne 1985, 186). In sum, the historical story of Japan’s
capital account liberalization tracks very closely to the visual in Figure 8.
Yet, despite the openness of Japan’s financial system by the early 1980s, we know from
Figure 1 that the yen still only comprised around 5 percent of international reserves. A full
decade later, the currency’s share still remained under 10 percent. Now, one explanation for
the yen’s mediocre performance as a reserve currency might be the structural factors previ-
ously discussed. In the 1980s, the U.S. economy began to rebound from its poor performance
in the previous decade. As the U.S. share of global GDP and global trade and the dollar’s
exchange rate all began to increase, international interest in the yen-denominated reserve
assets may have been stunted relative to the top currency. In other words, the explanation
may lie in factors largely out of Japan’s control. However, the yen’s limitations may also
have something to do with the relative immaturity of Japan’s financial markets. Just because
it became possible for foreign investors to purchase yen-denominated assets in Japan does
not mean it was easy or convenient–especially relative to the market for dollar-denominated
assets dominated by U.S. Treasury bills.
Garber (1996) laid out three reasons why the market for official yen debt instruments was
relatively illiquid and, hence, the currency’s prospects as a reserve currency were sorely
limited. First, he notes that the Treasury bill is typically regarded as the “proper instrument
for foreign exchange holdings” because it is both liquid and entails no credit risk. Yet, he
points out that by 1994–a full 20 years after the yen debuted as a reserve currency–only
one-forth of all yen-denominated foreign reserves were in Treasury bills.21 Second, Garber
noted that sellers of Japanese securities, including foreign central banks, were required to
pay a securities transaction tax.22 Additionally, interest income earned on yen-securities
21
According to Garber, most yen-denominated foreign reserves were denominated in the form of “financing
bills” issued by the Minsitry of Finance. Frankel (1984) came to a similar conclusion: “There has been no
traditional market in short-term government securities analogous to the US Treasury bill market...In recent
years the Bank of Japan has undertaken some sales of short-term government securities. But the market is
still very limited” (Frankel 1984, 50).
22
This tax did not apply to T-bills, adding to their attractiveness, but belied by their scarcity.
25was subject to a withholding tax. These combined to increase the transaction costs to
participating in yen-denominated securities markets–costs the U.S. market did not have.
Finally, he explains that until 1995, Japan did not provide investors with a “rolling settlement
system” for securities. While U.S. government securities are settled on the next business day,
Japanese securities could only be settled six times a month adding settlement risk that U.S.
securities did not carry (Garber 1996, 10-15).23
Garber’s ultimate conclusion is that such policies were intentional on the part of Japanese
authorities who, in his view, did not seem willing to bear the burden of providing a reserve
currency: the potential instability that comes with shifts in official foreign demand when a
money is widely held abroad. He neatly sums it up like this: “The question then becomes not
‘Who runs away from responsibility?’ but ‘Who runs from responsibility less rapidly than
everyone else?’ The answer determines who provides the reserve currency” (Garber 196,
19). Cohen (1998) draws the same conclusion noting that Japanese authorities tended to be
“ambivalent” about internationalizing the yen “fearing especially the increased constraints
on domestic policy” an increased share of foreign liabilities would impose (Cohen 1998, 163).
Thus, if Japan’s capital account openness made it possible for official reserve holders to invest
in yen securities, Japan’s capital account immaturity seems to have played a role in stifling
international demand. Coupled with the trend toward unfavorable structural conditions
throughout the 1980s, the yen’s muted rise as an international reserve currency is perhaps
not much of a surprise after all.
So, what about China? We know in a de jure sense, China’s capital acount is in fact quite
closed. Generally speaking, this is also true in the de facto sense. However, Beijing has taken
some small steps toward easing restrictions on foreign investment in renminbi-denominated
23
Cohen (1998) comes to a similar conclusion: “Japanese financial markets...have long lagged behind the
U.S. and even many European markets in terms of openness and efficiency. Indeed, only two decades ago,
Japan’s financial system was the most tightly regulated and protected in any industrial nation, inhibiting
wider use of the yen. Strict exchange controls were maintained on both inward and outward movements of
capital, securities markets were relatively underdeveloped, and financial institutions were rigidly segmented”
(Cohen 1998, 162).
26assets. Similar to the early development of the euroyen market, China has for several years
now allowed off-shore investment in renminbi securities issued in Hong Kong. The Chinese
“Special Administrative Region” is the global hub for so-called “dim sum” bonds: renminbi-
denominated bonds issued outside of mainland China.24 As of January 2013, the outstanding
volume of the dim sum bonds totals over $39 billion (244 billion RMB) and baloons to over
$60 billion (375 billion RMB) if CDs are included (Chen 2013). An unknown portion of
foreign investments in dim sum bonds have been made by official investors. Still, in terms of
the global bond market, however, these sums are a pittance. Moreover, if China truly wants
the renminbi to comprise more than a rounding error of foreign exchange reserves, it needs
to develop its on-shore renminbi bond market and make the currency fully convertible for
capital account transactions.
Beginning in December 2011, China took one small step in this direction when it launched
the so-called “Renminbi Qualified Foreign Institutional Investor” (RQFII) scheme which has
since been incrementally expanded. In short, RQFII allows foreign portfolio investment in
renminbi securities issued in mainland China with funds raised in Hong Kong. Chinese au-
thorities enforced a strict aggregate investment quota of 20 billion RMB or about $3 billion
(CliffordChance 2011). This quota was later increased to 270 billion RMB, or around $43
billion (Chen 2013). To date investors can (and reportedly have) included foreign central
banks. However, the strictly enforced quota as well as the approval process has resulted in
relatively tiny sums of renminbi securities issued inside China. Based on the People’s Bank
of China (PBC) 2012 Q3 Monetary Policy Report, the first three-quarters of the year saw
Chinese authorities approve a mere $9.18 billion under the RQFII scheme.25 Even if such
limits are removed, foreign investors will be cautious about how much they invest in ren-
minbi securities until the currency is fully convertible. For instance, Russia and Kazakhstan
have each expressed interest in adding renminbi to their reserve portfolios, however, both
24
Note: The Chinese Development Bank is the key official issuer of dim sum bonds.
25
For full text of recent PBC monetary policy reports, please see: http://www.pbc.gov.cn/publish/
english/957/index.html
27governments have indicated they will only consider holding the currency when it becomes
fully convertible (Li 2011; Orininskaya 2011). Without this assurance, renminbi holders may
fear they cannot liquidiate their assets in the face of adverse financial developments.
China also faces another dilemma: how to sequence liberalizing its capital account and
liberalizing its exchange rate policy. The PBC closely manages the renminbi’s exchange rate
having implemented a de facto hard or soft peg (depending on the year) to the dollar for
over a decade now. Recently, the PBC has loosened its grip a bit and allowed the currency to
gradually appreciate against the dollar (as it did from 2005-2008) but the renminbi retains an
exchange rate that is far closer to a pure fix than a pure float. Scholarly research on the proper
sequencing of these matters has concluded that it is risky for a country to fully liberalize its
capital account and attempt to maintain a fixed exchange rate (See Prasad, Rumbaugh, and
Wang 2005). Numerous financial crises in emerging markets in the 1990s raised–and seem
to confirm–these fears. In Japan’s case, Tokyo allowed the yen to float beginning in 1973,
a few years prior to the country’s most aggressive decade of capital account liberalization.
Chinese authorities have a decision to make: Do they want renminbi internationalization
bad enough to give up control of the exchange rate? Of course, at least part of the attraction
at the moment to purchasing renminbi securities is the widely held belief that the currency
is substantially undervalued and, therefore, is a smart investment at the present moment.26
Once allowed to float freely and appreciate, this motivation should be reduced.
It is impossible to predict the pace at which China will liberalize its capital account, when
it will make the renminbi fully convertible for capital account transactions, and when it will
allow the renminbi to float. There have been some reports that Chinese authorities have made
some private assurances to foreign investors that the renminbi will be fully convertible by
2015 (Li 2011). In September 2011, China released the 12th Five-year Plan for the Financial
Sector where it vaguely commits to “market based” reforms with respect to interest rate and
26
According to one report, Nigeria’s decision to shift some of its reserves into renminbi was based in part
on “bets the currency will appreciate” (Li 2011).
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