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Yen’s steady drop in foreign reserve status reflects wider worries

by Teruhiko Mano

Ten years have passed since the euro was launched as a common European currency by 12 members of the European Union based on the Maastricht Treaty of 1992. The euro was initially used only for interbank trading and other electronic transactions, but the debut of euro notes and coins on Jan. 1, 2002, put an end to the national currencies of the participating countries, including the German mark, which rose to prominence after Germany raced with Japan to rebuild from the ashes of World War II.

The currency regime set up by the International Monetary Fund was an adjustable system of fixed exchange rates based on gold and the U.S. dollar as standards. It shifted to floating exchange rates in 1973. The floating rate regime — occasionally called a system without a system — is the one we use today and is one of the reasons why the world still lacks a global currency to replace the U.S. dollar. Even though the euro zone countries have a combined gross domestic product larger than the GDP of the United States, the euro remains unready to perform as a global currency for several reasons.

For one, some of the EU countries, including Britain, have not yet bought into the euro. The participation of former Soviet bloc countries meanwhile has expanded the income gap among euro zone nations. And the euro zone still lacks a coherent economic policy as a region because responsibility for fiscal policy remains in the hands of each individual member country.

This may all be natural, given the euro is only 10 years old. But let’s take a quick look at the international currency situation to see which currencies are most favored as foreign-exchange reserves worldwide.

The dollar, which has fallen to about a fourth of its ¥360 exchange rate value under the fixed-rate currency regime, still accounts for a dominant 65 percent of all foreign-exchange reserves. The euro is second at 25 percent.

The fact that these two currencies together account for 90 percent of all foreign-exchange reserves tells us something about the future of the global currency regime.

Before the euro was introduced, the Japanese yen was No. 3 at 6 percent of all foreign-exchange reserves, trailing the German mark, which accounted for 14 percent. The yen has since been surpassed by the British pound, which has garnered a 4 percent share, and now accounts for less than 3 percent of foreign currency reserves worldwide.

It is undeniable that economic factors have driven this fall. Japan’s growth declined as its economy matured. It lost a decade of growth opportunities when its real estate bubble collapsed, and after a subsequent export bubble fueled by an intentionally weakened yen was popped by a global recession ignited by Lehman Brothers’ bankruptcy last year.

But a bigger factor behind the yen’s declining international trust is global concerns about Japan’s national security. Overseas investors are wondering whether Japan can defend itself. Can they afford to keep their money in a bank that does not have security guards?

Furthermore, the massive dollar-buying, yen-selling intervention Japan used to engage in to keep its export engine primed brought on a situation in which yen holdings effectively stopped producing interest. When the yen’s value itself doesn’t budge, investing in yen-denominated assets becomes much less attractive.

While it is true that the yen has recently soared against the dollar, that was more the result of the dollar falling. The yen hasn’t climbed that much against the euro. Gold’s rise to $1,100 an ounce is attributable to the fall of the dollar, the yen’s low interest rates, and demand for a hedge against continuing economic uncertainties. Today, the yen’s real effective exchange rate, calculated to account for trading volumes and inflation gaps, is more than 10 percent lower than a year ago.

The 21st century is often called the century of Asia. But we no longer live in an era where Japan is the only advanced economy in the region. The area has undergone rapid changes in its economic and military landscapes, and Japan now faces threats from its closest neighbors, including China’s ongoing military modernization and North Korea’s ambitious nuclear and missile programs.

“From Japan bashing to Japan passing” is the phrase often used by those concerned the world is beginning to bypass Japan. U.S. President Barack Obama, in his first official visit to Japan last week, stressed the importance of the U.S.-Japan alliance even as Washington stepped up dialogue with Beijing on trade and other issues.

The U.S.-Japan security treaty is an agreement between states, and the change in governments that took place this year in both countries does not affect this agreement. I strongly hope the Japanese government recognizes the declining trust in the yen and takes steps to bolster the security of the nation, including through the security alliance with the United States.

Teruhiko Mano is chairman of the Mano Economic Intelligence Forum.