Foreign Exchange Reserves

Ichiro Suzuki Contrary to all the headlines on Japan’s economic malaise, the country’s foreign exchange reserves remain solidly abundant, if not growing. At the end of June, 2022, Japan held $1.3 trillion in FX reserves, that is approximately a third of the size of the economy. In recent months, the country’s current account surpluses are under pressure because of a sharp upswing in the prices of crude oil, which is the single largest import item, and epic weakness of the currency since the beginning of the year. Since international commodity prices are quoted in U.S. dollar, a combination of price hikes and a weak currency is devastating. The country’s trade account has been in red for sometime, due to retreat of made-in-Japan products in the global markets over the last few decades. Trade deficits have been easily made up for by surpluses in the non-trade account. As an exporter of capital, Japan has been receiving massive amount of interests and dividends from investments in overseas assets, with most notable of them being U.S. Treasury securities. Corporate Japan’s overseas subsidiaries have been registering handsome profits. Manufacturers, notably car makers, are not exporting as aggressively as they once did a few decades ago. Instead, they produce at where the customers are and such operations are in good shape generally. While factories outside the country adds nothing to gross domestic product (GDP), they boost gross national income (GNI). This matters to the current account though profits made by Toyota America may never cross the border to come back to Japan. Capital inflows of this kind is sticky since they are the fruit from long-term developments, whereas the trade account shows a snap shot of what is going on today. Recently witnessed negative current account numbers confirm the the size of trade deficits that interests and dividends from overseas investments are insufficient to offset. It has been argued that current account surpluses at 2-3% of GDP has been a root cause of deflation, since surpluses tend to push the yen up and much of the surpluses tend to flow into Japanese government bonds eventually, thus suppressing long-term interest rates. From this perspective Japan has got what the country has wished for. Since the beginning of 2022, the Japanese yen has been falling in a spectacular fashion by the standards of developed world currencies. Among all the currencies falling against the dollar, the yen’ weakness still stands out, as the Bank of Japan continues to hold onto a policy of printing money to keep the economy afloat. There are some speculations on the Ministry of Finance’ intervention in the market to stem the yen’s slide. Most likely it is not going to happen, at least not in a serious fashion. Selling the dollar in the market can be done only by liquidating a part of Treasury securities holdings. ‘Defending a currency’ is a sure way to make the matter worse, by depleting FX reserves. Developing countries have a habit of repeating this folly time and again, and Turkey is the most recent case. China on the other hand has $3.2 trillion in FX reserves, which is less than a fifth of the size of the economy. Despite all the headlines on spectacular wealth accumulation, China is not as ‘wealthy’ as Japan is, at least from this perspective. China’s current account, after having ballooned to over 10% of the economy earlier in this century, has stabilized in recent years at more modest levels. In the pre-pandemic years, Chinese tourists’ spending spree overseas made a huge dent on the country’s current account, leading to speculations that tourists would drive the account into deficits. Since then COVID-19 has made Chinese people stay home to erase such worries though higher energy prices are negative on the current account. China have not yet built assets outside of the country, not in a magnitude Japan has done. In the middle of the 2010s, Chinese investors’ voracious appetites for prime real estate, i.e. The Waldorf Astoria in New York, caught attention in the market. They have certainly overpaid for such assets that probably have not come to the point of paying dividends to investors in a meaningful fashion yet. Even worse, there is a reasonable chance that Xi Jinping’s Belt & Road Initiative is negative on China’s external accounts. It is hard to believe that many of the BRI projects are generating sufficient cash, at least up to now. If China has equity stakes in those projects, the equity position must not be generating returns at all. If China is strictly in the business of lending money at higher rates than the World Bank, it is still not a great business since many of the borrowers are struggling to serve the debt and crying for rescheduling. In addition, China’s holding of U.S. Treasury securities is currently touch above $1 trillion, well behind Japan’s $1.3 trillion. While T-notes and bonds account for essentially all of Japan’s FX reserves, these U.S. securities represent less than a third for China’s. Then where are the two-thirds that is not in U.S. Treasury securities that are most liquid and safest asset on earth, whether one likes it or not. There must be some allocation to Euro-denominated sovereign debt or Japanese government bonds. Neither of them match T-notes in liquidity. Both of them are yielding significantly lower than T-notes, and Japan offers materially inferior quality due to the country’s mountain of debt. Comrade Putin’s sovereign debt offers a junk status. Only a fool would invest in them and China probably has no interest in them. BRI client states’ debt is in even worse quality than that of Russia. Debt security holdings of other countries than the U.S. is considered to be insignificant, anyway. That leaves a huge portion of China’s foreign exchange reserves unexplained. Gold is obviously held at the vault of the People’s Bank of China. In addition, it is speculated foreign direct investments (FDI) account for the majority of the unexplained portion. Cash flows into China’s capital account when corporations in the developed world build factories or acquire office space in China. The cash is soon converted into fixed assets. While such assets may stay as FX reserves, their lack of liquidity makes them not usable in the event of emergency. To be specific, such assets don’t enable China’s Ministry of Finance to defend the renminbi should the currency come under attack in the market, or to make payments to foreign creditors in a highly unlikely event of China facing such difficulties. In any case, China’s FX reserves looks a bit like a paper tiger, not of the comparable quality with Japan or many Western European countries. Besides, it remains to be seen how Beijing reacts to heavy downward pressure on the RMB, the one the yen is going through today. A text book response should be ‘let it be’. The hyper stability-conscious Communist Party, however, might frantically defend the currency in vain, thus draining FX reserves that may not be as abundant as they look on the surface.

About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.