Ensuring Appropriate and Stable Exchange Rates
A Report of the Policy Subcommittee of the Committee on International Finance
September 11, 1995
- Although more than twenty years have passed since the adoption of the floating
exchange rate system in 1973, contrary to earlier expectations, the system has not led to a
quick correction of current account imbalances. Instead the system has brought on drastic
swings in exchange rates and created wide gaps between actual and appropriate rates,
adversely affecting the national economies of many nations as well as their business
activities. (See Note 1)
- Since the beginning of 1995, the value of the yen surged greatly against the US dollar
and in April reached the unprecedented level of less than 80 yen to one dollar. In response,
following the Bank of Japan's guiding money market rate below effective rates on July 7th,
on August 2nd the Government announced its incentive package, "Measures to Promote
Overseas Investments and Loans Aiming for Correction of The Yen Appreciation", and
working with the US and Germany, launched a coordinated intervention effort in the
exchange markets. Along with other forces, these efforts have gradually slowed the yen's
appreciation, although it is still over-valued in relation to Japan's current economic capacity.
The overly strong yen, coupled with drastic swings in exchange rates, have seriously
handicapped business activities, thwarting spontaneous economic recovery and creating the
potential for a "hollowing out" of Japan's industrial and technological infrastructure, which
could lead to serious job-loss. Japan must take the necessary measures to ensure that the
yen is staying at appropriate level and that exchange rates around the world be stabilized.
- To support these efforts, the Policy Subcommittee of Keidanren's Committee on
International Finance has compiled this report, which presents the position and policy
recommendations of the business community on issues relevant to the exchange rate. We
hope that it will serve as a point of reference for the Government and the business
community, as they work together to ensure exchange rate stabilization. In cases where the
Committee expressed conflicting opinions on issues, we have noted the diversity.
- This report outlines the measures that the Government and the private sector should take
to correct the over-valued position of the yen. It goes on to make policy recommendations
on issues such as structural reform of the Japanese economy, internationalization of the yen,
and reform of the international monetary system, from the perspective of stabilizing
exchange rates over the medium to long-term.
- Achieving Appropriate Exchange Rates
In response to the negative effects of the over-valued yen, the private sector has undertaken a
number of initiatives, including:
- increasing the percentage of foreign content in domestic products;
- promoting overseas production of finished products and key components for domestic use;
- expanding exports from overseas subsidiaries.
However, the threat of unemployment in Japan limits the impact of such initiatives. There
is an urgent need to correct the imbalance in the foreign currency supply and demand, which
results from the imbalance the current account balance and the capital account balance. Put
together they drive yen up high. Japan must first reduce its current account surplus, and
recycle it by encouraging overseas investments and loans. The Government must also use
timely intervention and other measures to correct the differential between actual and
desirable exchange rates.
- Understanding the Yen's Strength
In May 1995, Keidanren conducted a survey of its members which found that business
believes an exchange rate of approximately 100 to 110 yen to the dollar would be the most
desirable to the Japanese economy. (See Notes 2,3,4) However, at this time when capital
transactions represent a significant percentage of all exchange, rates tend to swing violently
over the short-term. As far as the Yen is concerned, it is causing rapid yen appreciation.
In past it had an extremely negative effect on the business activities. International
movement of capital created the trend, anticipate movement and changes in supply and
demand of the foreign exchange markets. (See Note 5).
Japan's enormous accumulated current account surplus along with the huge current account
deficit of the US applies increasingly upward pressure in the foreign exchange markets. In
the market where actual demand governs the sale of dollars, there is a belief that the yen will
continue to appreciate.
Exchange rate speculation serves to amplify the dramatic rate swings and contributes to yen
appreciation. However, speculation in the form of hedge funds would have a limited
impact on exchange rates, since such speculation would eventually push the exchange rate
back to its original position within a matter of time. (See Note 6) These conflictive
comments alerted us to the need to clearly define the term "exchange rate speculation" and to
identify effect speculation has on the exchange markets.
- Reducing Japan's Current Account Surplus
It is obvious that Japan's accumulated current account surplus is the primary factor pushing
the yen to higher levels. Given the reality that the Japanese economy is suffering because of
the huge gaps between supply and demand, the Government must attempt to stimulate
domestic demand, particularly in the form of private investment.
Measures the Government should undertake include:
- fiscal management that includes front-loading of the "Basic Plan for Public Investment";
- tax reform including reduction of the corporate tax burden by cutting the corporate tax
rate and eliminating land value tax, and;
- To reduce cyclic factor that accumulate surplus, promote import through deregulation
and improved market access.
The Government should use the expanding equilibrium of economy resulting from these
initiatives to reduce the current account surplus. (See Note 7) For its part, the private sector
must continue its efforts to increase imports by undertaking reforms such as eliminating
business practices which bars imports.
- Promotion of Overseas Investments and Loans
Other avenues of action that the Government should actively pursue include encouraging the
private sector to make overseas investments and loans, thereby recycling the current account
surplus and reducing the upward pressure on the yen. In this context, we endorse the
initiative, Measures to Promote Overseas Investments and Loans, Aiming for Correction of
Yen Appreciation, recently released by the Ministry of Finance, which will promote overseas
investment and loans by institutional investors. We believe that further efforts must be
made to promote deregulation in these areas as well.
Unfortunately, however, asset deflation within Japan has reduced the ability of Japanese
institutional investors to take the risks inherent in overseas investments and loans.
Therefore, the Government should adopt measures to thwart asset deflation -- the key
measures being revision of the securities and land tax systems -- which would improve the
investment climate, enabling investors to make overseas investments entailing foreign
On the other hand, contrasting opinions hold that since the working assets of institutional
investors are in yen, Japanese who invest in foreign bonds in a foreign currency will
eventually sell and reconvert their assets into yen, negating the impact long-term overseas
investments would have on exchange rates.
- Strategically Planned & Coordinated Intervention
At the April 1995 G-7 Meeting Of Finance Ministers and Central Bank Governors,
agreement was reached on an "orderly reversal" of exchange rates, which resulted in
implementation of a number of coordinated intervention measures that proved effective in
partially correcting the over-valued yen. This type of strategically planned & coordinated
intervention by monetary authorities is an essential prerequisite for controlling dramatic
swings in exchange rates and for bringing rates within desirable limits.
However, global market intervention is effective only if supported by government
implementation of appropriate policy initiatives and only when the initiatives are supported
by those active in the market. Therefore, there would be no value in attempting to guide
exchange rate levels away from the level indicated by economic fundamentals. (See note 8)
We must emphasize that any intervention must be coordinated with the above mentioned
macro-economic measures to address the over-valued yen.
- The Impact of Derivative Transactions
Derivative transactions have now made possible the practice of risk hedging with small
amount of capital. And, if the overall perception in the market is in a similar range, rates
will adhere to a predictable pattern. A large number of these small transactions can easily
concentrate within a particular range and accelerate exchange rate fluctuations, increasing
their amplitude. This is why, we must conduct extensive research on the impact of
derivatives, taking into consideration the uniqueness of derivative transactions when the
market is growing.
- Stabilization of Exchange Rates
In order to stabilize exchange rates over the medium to long-term, the first step must be the
structural reform of the Japanese economy. Another critical step is to internationally
coordinate macroeconomic policies to ensure that the present floating exchange rate system
works properly. A third step would be to initiate further discussions at home and abroad on
the future of monetary systems.
- Structural Reform of the Japanese Economy
The external imbalances which characterize Japan's economic relationship with the
international community are a reflection of the imbalances within our domestic economy.
We need deregulation; we need a reduction in the differential between domestic and foreign
prices (especially we need to improve low productivity in certain businesses sectors); we
need to make significant social capital expenditures. These measures would correct the
structural imbalance between savings and investment within the economy and would help to
establish an economic structure that balances domestic and foreign demand and is in
harmony with other nations' economic needs.
- International Coordination of Macroeconomic Policies
While we cannot expect immediate international agreement on a new monetary system to
replace the present floating exchange rate system, the negative aspects of the system should
be addressed through international coordination of both macroeconomic policies and market
intervention efforts in order to stabilize exchange rates. The coordination of
macroeconomic policies would make possible the convergence of economic performance of
industrialized nations and the mutual monitoring of economic policies of the countries
The Government should draw up a comprehensive plan to reduce the current account surplus,
based on expansion of domestic demand and thorough deregulation. It should also clearly
demonstrate to the nation and the international community its determination to push forward
with structural reform of the Japanese economy and then take a proactive approach to
reaching this goal. We suggest that in conjunction with these efforts, the Government again
call on the US to strengthen its efforts to cut its twin deficits -- the fiscal and trade deficits.
However, there is a contrary opinion regarding international coordination, noting that even if
governments set out to coordinate their policies, they would often end up placing a higher
priority on their own domestic policies than on cooperative exchange rate policies. This
could limit the effectiveness of coordination as a tool to stabilize exchange rates.
- Making the Yen as a Key Currency
A key currency country like the US is easily able to finance its current account deficit. It is
said that this is the reason why the US has lost some of the "self-control" required to ensure
moderation in managing its economy and this is the major cause of the dollar's instability.
Other nations must single-handedly take responsibility for stabilizing exchange rates, which
means a lack of symmetry between their macroeconomic policies and those of the key
currency country. It also indicates the instability of the current international monetary
system with its excessive dependence on the dollar.
The establishment of a tri-polar monetary system should be considered in which the yen, and
mark or European Union currency could serve together with the dollar as key currencies.
Such a system would serve to restrain American economic policy and could possibly lead to
currency stabilization in the international markets. (See Note 9)
There is, of course, possibility that the yen as a key currency would encourage foreign
investors to increase their percentage of yen-denominated assets, which would in turn,
increase the demand and temporarily push the yen to even higher levels. The Policy
Subcommittee intends to study this issue further in order to identify exact measures, as well
as the speed at which the Yen becomes a key should proceed.
- Establishment of Target Zone
Since the floating exchange rate system obviously does not function as well as expected,
there is a wide variety of proposals for alternative monetary systems to address the future
needs of the international community. For example, suggestions were made to return to the
fixed exchange rate system or to the gold standard, or to establish target zone mechanism.
The proposal urging the establishment of the target zone mechanism has generated
considerable discussion recently. (See Note 10)
- the system would help stabilize exchange rates and improve foreseeability of
- it would require systematic policy coordination, which in turn would make it possible to
pressure the US and other major industrialized nations to exercise greater moderation in
their macroeconomic policies.
By contrast, other opinions stressed, that establishing the target zone mechanism at this time
when the economic interests of the international community are so intertwined, would be
an extremely difficult task. One need only look at the EU's efforts to maintain such targets
to comprehend the challenge. Some of the potential problems noted were:
- the difficulty in obtaining agreement on an exchange rate level that would define the
- the absence of guarantee that each nation would shoulder the responsibility of ensuring
stability of its own currency, and;
- the possibility that maintaining agreed-upon exchange rates could lead to make grave
domestic economic sacrifices.
Because of the vulnerability of monetary systems to a myriad of problems, effort is required
to continue to improve the present monetary system seeking to design a new monetary
system. In the half century since creation of the Bretton Woods System, the world's
economies have experienced many changes, first under the fixed exchange rate system and
then under the floating system. Now is the time to put this experience to good use, through
vigorous international discussions focused on designing a monetary system best suited to the
needs of the 21st century.
Under the floating exchange rate system, it is theoretically possible to seek domestic balance
in macroeconomic policies, thereby ensuring that each nation is able to control its own
monetary and fiscal policies, because of the following factors:
However, in reality the floating exchange rate system has not functioned as well as expected,
due to the fact that:
- current account imbalances are automatically adjusted as a result of the coordinating
mechanism of exchange rates, and;
- the impacts of inflation, interest rate variations and other factors which are affected by
overseas developments, are absorbed by the fluctuations of exchange rates.
- there is a long time lag in the process of correcting current account imbalances as a result
of the effect of the J-curve, the growing globalization of corporate activities in all nations,
including a variety of other factors;
- the currency markets are much more volatile than anticipated, in terms of short- term
swings and departures from optimal exchange rates, and at times have a serious negative
impact on all nations' economies, and;
- the macroeconomic policies and economic disturbances of one nation tend to influence
other nations' economies unintentionally in a kind of spill-over effect.
In a survey conducted by Keidanren in May 1995, 41% of corporations responded that 100
to 110 yen to the dollar was desirable and 32% 110 to 120 yen to the dollar. The average,
exchange rate during May 1995 was 85.10 yen to the dollar.
One method of calculating a equilibrium exchange rate for the Japanese economy -- a rate
which effects a balance in macroeconomic factors -- uses purchasing power parity. The
underlying principle of this approach is a belief that, in a relationship between two nations, a
"one product, one value" principle exist to allow exchange rates be determined by the
This method of calculation is ordinarily called the "relative purchasing power method" and
uses as a standard reference year, a point in the past which predates the appearance of an
imbalance in rates, in order to calculate the ratio of change that has occurred in the
commodity price levels of both nations since that point in time.
The relative purchasing power index is calculated using the following formula:
Relative Purchasing Power =
[(Current Commodity Prices / Commodity Prices of Reference Year) in Japan]
(Yen Value At Reference Year) * -----------------------------------------------------------------------------
[(Current Commodity Prices / Commodity Prices of Reference Year) in the U.S.]
For example, the relative purchasing power method for trade commodities, when used with a
cargo and service export deflator, in conjunction with the second quarter of 1973 as the
reference year, produces a yen-dollar ratio of 103 yen to the dollar for the first quarter of
Japanese exports consist of yen-based and foreign currency-based export contracts. Within
the sector composed of foreign currency-based contracts, yen appreciation, in general, tends
to proceed export prices As a result, if an analysis is made on a yen basis, there is a lag in
the speed at which the overall value of export prices increases. For this reason, the actual
exchange rates must fall somewhat below purchasing power parity.
With regard to the method of calculating purchasing power parity, we found diverging
opinions, on issues such as "which year to name as the reference year" and "what price
indices to use as a standard" -- calculation results differ greatly. For example, when the
reference year is the second quarter of 1973 and wholesale prices are used as a standard,
purchasing power parity for the first quarter of 1995 works out to 154 yen to the dollar.
Respondents also mentioned other problems, such as the fact that calculations of purchasing
power parity do not take into account changes in industrial structure or differences in
consumer preference regarding product quality. This means that one cannot easily arrive at
a definitive conclusion through the use of purchasing power parity calculations.
This difficulty prompted submission of a proposal to calculate a equilibrium exchange rate
using industrial productivity as the standard. For example, using Japanese and American
labor productivity in the machine industry (the industry thought to best indicate the actual
capability of export industries), and 1973 as the base year, would yield a long-term
equilibrium exchange rate of 112 yen to the dollar. (Source: Sanwa Research Institutes
There is a possibility that prices in Japan will continue to decline for several years, while
basing purchasing power parity on an inflation based rate would have the effect of creating a
theoretical value to even a higher level of the yen.
A survey of foreign exchange bank transactions during FY 1994 indicates that import/export
transactions constituted about 4% of the total, while capital transactions occupied about 85%.
For example, if American currency speculators buy yen on the assumption that it will rise in
value, in order to realize either a profit or loss, they would have to sell the yen and buy
dollars within a certain time frame.
One can assume that the current account surplus actually consists of two surpluses:
- - a surplus related to cyclical factors, resulting from two nations in different phases of the
economic cycle, and;
- - a surplus related to structural factors, resulting from a structural imbalance between
savings and investment.
Surpluses stemming from cyclical factors can be corrected through such measures as
expanding domestic demand and increasing imports. However, Japan's surplus related to
structural factors is based on Japan's basic social and economic structures. This surplus can
only be reduced by stimulating domestic investment and by utilizing excessive domestic
Economic fundamentals which influence exchange rates include the current account, interest
rates, and consumer prices indices.
If a monetary system in which a plural currencies supports the dollar, all those nations
involved in the plurality would have a vested interest in the stability of the key or baseline
currency. As a result, a certain degree of mutual monitoring of each others' economic
policies would be inherent in the system. In other words, if the level of use of the dollar
dropped, the US would not be able to remain disinterested in the international account
balance. This in turn would serve as an incentive for reform of the economic and fiscal
policies of the US and would contribute to the balancing of macroeconomic policies.
This envisions an international monetary system supported by an agreement on maintaining
equilibrium exchange rates and in which macroeconomic management is imposed on each
country when exchange rates fluctuate beyond a certain point.
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