By Andrew Sheng

(Caijing.com.cn) Japan was ranked the world's second largest economy at the end of 2008 with a GDP of US$ 4.8 trillion, following the United States and its US$ 14.3 trillion GDP. Because of consistent current account surpluses, Japan has enjoyed the world's largest net foreign exchange position – that is, more foreign exchange assets than liabilities – with US$ 5 trillion in gross foreign exchange assets and US$ 3.1 trillion in net foreign exchange assets at the end of September 2008.

By contrast, China posted a US$ 4.4 trillion GDP, gross foreign exchange assets of US$ 2.3 trillion, and net foreign exchange assets of US$ 1 trillion at the end of 2007. In other words, Japan's net foreign exchange assets are three times greater than China's, even though China has more foreign exchange reserves.

Japan's economic clout cannot be denied. So why did a bid to make the yen an international reserve currency fail so miserably?

In the 1960s, when the yen was fixed at 360 to the U.S. dollar, the Japanese economy grew at an average 10 percent per annum. In the 1970s, when the yen began to appreciate during an oil shock, growth slowed to an average 5 percent.

Following massive stock market and real estate bubbles after the 1985 Plaza Accord, the yen appreciated sharply against the dollar. In 1992, the Japanese currency rose to 128 to the dollar from 239. Appreciation continued until April 1995, when the yen hit 80, and then followed a reverse course until falling to 147 in June 1998, a decline brought to a halt only after joint intervention by the Bank of Japan and U.S. Treasury.

According to economics textbooks, a country with a constant surplus should have an appreciating currency. It is interesting to note that Japan continued to have a current account surplus through the yen's period of volatility. Indeed, Japan had to export large amounts of capital to keep the yen competitive.

In the 1980s, Japan began to internationalize the yen in an effort to make it a reserve currency and promote Tokyo as an international financial center. However, during 17 years of dismal economic growth, with annual GDP rising 1 to 2 percent at best, the yen's role has been on the decline. The number for foreign companies listed on the Tokyo Stock Exchange has been falling as well.

The yen's failure to reach international reserve currency status followed a Japanese campaign to actively promote its currency. One way was to grant considerable amounts of cheap, official aid through loans in yen. Japanese banks that branched overseas in the 1980s issued substantial yen loans abroad.

Because yen interest rates were low, many countries initially borrowed in yen. But they soon discovered that high volatility in dollar-yen exchange rates made the Japanese currency quite costly for hedging and borrowing.

The yen was pushed as an international reserve currency and Tokyo as an international financial center for strategic reasons. Given an aging population, Japan wanted to diversify from manufacturing exporter to a cash surplus country that could expect long-term income from savings. If the yen served as an international reserve currency, the Bank of Japan could earn seigniorage – interest-free loans from foreigners that use the yen as reserve currency. Furthermore, Tokyo could have earned services income as an international financial center by handling yen securities, currency trading and commercial services.

So the yen's inability to achieve major reserve currency status, despite the wealth and industrial power of Japan, may have seemed strange. But an international reserve currency must meet three conditions: stable value, low transaction costs, and high transparency. Unfortunately, the yen exchange rate has been volatile and transaction costs have not always been cheap.

Several factors contributed to the yen's volatility, but policy errors lead the list. First, Japan's position as a major yen exporter created a yen "overhang." A Japanese investor in U.S. Treasuries earning a spread of, say, 4 percent between a Treasuries rate and a Japanese deposit rate would find his income wiped out if the yen appreciated more than 4 percent a year -- which happened quite often.

Likewise, a Thai borrowing in yen would find that yen appreciation wiped out whatever savings were possible if borrowing in yen was less expensive than borrowing in Thai baht or U.S. dollars. The borrower, however, would be naturally hedged if his earnings were in yen.

But due to a long-term tendency of the yen to appreciate, Japanese exporters preferred to export in yen and import in dollars, thus protecting their incomes in yen terms and saving import costs when the yen appreciated.

This practice of passing foreign exchange costs to borrowers made the yen more volatile. So now, whenever the yen begins to appreciate, both borrower and investor sell dollars to buy yen to protect themselves from appreciation, which in turn creates wide swings for the yen's exchange rate.

A reserve currency is also usable when a wide variety of financial and real assets are available for purchase with attractive yields in liquid markets. Since the massive asset bubble that appeared in Japan in 1989, financial assets and real estate have been basically trending downward, while yields on Japanese bonds, stocks and bank deposits have been low under a nearly zero-rate interest policy. Hence, dollar-yen turnover has steadily declined, reaching 13 percent of global foreign currency turnover in 2007 compared with 20 percent in 1998.

The position of the yen as a possible reserve currency was further undermined by the rise of the euro in 1999, which we'll explore in a future column.

Andrew Sheng is an adjunct professor at the University of Malaya and Tsinghua University.