Ensuring Appropriate and Stable Exchange Rates

Keidanren
September 11, 1995

Introduction

1. 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)

2. 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.

3. 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.

4. 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 exchange risks.

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 involved.

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 corporations; and
• 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 target;
• 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.

Note 1.

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:

• 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.

However, in reality the floating exchange rate system has not functioned as well as expected, due to the fact that:

• 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.

Note 2.

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.

Note 3.

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 purchasing power.

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 1995.

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.

Note 4.

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 Corp.)

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.

Note 5.

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%.

Note 6.

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.

Note 7.

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 savings effectively.

Note 8.

Economic fundamentals which influence exchange rates include the current account, interest rates, and consumer prices indices.

Note 9.

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.

Note 10.

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.