Rolling Back the Strong Yen under a Dollar Reserve Currency Regime

◆With S&P* downgrading its credit rating of US Treasuries in August 2011, confidence in the dollar, which serves as the world’s reserve currency, appears to have been shaken. In this report, we examine the sustainability of the dollar reserve currency regime and the impact it has had on Japan's economy. We then offer proposals from the perspective of the foreign exchange system on what can be done to roll back the strong yen and deflation from which Japan has suffered for a protracted period.

*This report uses credit ratings assigned by S&P, which is not registered with Japan’s Financial Services Agency pursuant to Article 66, Paragraph 27 of the Financial Instruments and Exchange Act. Investors should refer to the related attachment at the end for information on ratings assigned by unregistered rating agencies.

◆Given a global economic and financial structure where a substantial portion of current account and capital account transactions depend on the dollar, it is unrealistic to suddenly abandon the dollar just because confidence in the US currency has slipped. This is because if nations avoided using the dollar their foreign exchange transaction costs would increase sharply. Although transactions involving the euro are substantial, there are questions about its stability, for which no solution is yet in sight. In the case of the yuan, transaction volume is small, and capital account transactions are not liberalized. The yuan simply is not ready to replace the dollar at the present moment. Thus, we believe the dollar reserve currency regime will continue even as reduced confidence in the dollar entails its ongoing depreciation.

◆Since the US is not fully fulfilling its obligations as a reserve currency nation, the sustained depreciation of the dollar is foreseen to continue. Given this outlook, the perpetuation of the dollar reserve currency system is not necessarily desirable for Japan with an economic structure that is vulnerable to a weaker dollar in both flow and stock terms compared to other nations. The excessive fluctuations associated with a floating exchange rate system not only directly worsen Japan's economy but they also have the indirect effect of restraining growth of nominal wages as exporting companies endeavor to maintain cost competitiveness in the face of a weaker dollar (a stronger yen). Such corporate behavior has produced a vicious cycle of sluggish domestic demand, deflationary pressure, and the further appreciation of the yen.

◆If Japan is to roll back the overly strong yen, there will be a need to work toward the building of multilateral rules to control the excessive fluctuations of a floating exchange rate system. Also, it should prove effective if Japan actively takes part in the economic development of Asia (excl. Japan) and Europe to indirectly encourage the US as a partner to exercise the discipline of a reserve currency nation. Moreover, Japanese manufacturers seeking to make products whose selling prices do not fall and to develop marketing methods where selling prices need not be reduced will be highly significant.