Japan’s foreign exchange misadventure

Japan’s public finances are in dire straits, with government debt already twice the size of the country’s GDP and still growing at an alarming rate.

Juxtaposing its debt, the Japanese government also holds substantial assets, most notably through its foreign exchange reserves. Thanks to its active exchange market interventions, Japan’s official exchange reserves stand at US$1.3 trillion — five times the amount held by the rest of the G7 countries combined. At least 90 per cent of these reserves are invested in assets that can be liquidated easily.

But the Japanese government has no intention of liquidating these assets. The government insists that drawing down its foreign exchange reserves and converting them into yen will put upward pressure on the currency’s value and risk harming the country’s already frail export industries.

Nevertheless, the fear of an appreciating yen is not the only reason why the Japanese government is reluctant to liquidate its reserves. Other motives can be inferred by inspecting Japan’s Foreign Exchange Fund Special Account (FEFSA), which ostensibly funds the government’s exchange market operations.

When the Japanese government steps into the foreign exchange market, it first raises the necessary funds by issuing three-month financing bills (FBs) denominated in yen. The government then sells yen for US dollars and other foreign currencies, which are subsequently held in the form of US government bonds and other foreign currency assets. So even if the government’s initial intention is merely to resist an appreciation of the yen, the FEFSA serves as a government-sponsored investment vehicle. This investment vehicle is financially risky because it relies on short-term yen liabilities to fund long-term foreign currency assets.

Since the yen has been strengthening against other major currencies, the FEFSA has been incurring substantial exchange rate losses. But rather than formally acknowledging these losses, the government simply accumulates them on the FEFSA’s balance sheet indefinitely. At the current exchange rate of 77 yen to the dollar, the FEFSA’s cumulative book loss amounts to some 40 trillion yen (US$489 billion), whereas the outstanding stock of FBs is worth over 120 trillion yen (US$1.5 trillion).

The government also exploits the FEFSA to dress up its general account, which administrates its central budget, and is therefore the object of intense scrutiny. According to Japan’s fiscal law, each special account is required to settle its balance at the end of the fiscal year and surrender its profits to the general account, except for a small portion that is retained as a contingency fund. The FEFSA funds its long-term investment with short-term debt and ignores exchange losses altogether, so the return on its assets far exceeds the rollover cost of outstanding FBs, allowing the FEFSA to report substantial profits (joyokin) every year.

However, the FEFSA’s joyokin is not a realised profit but a mere accounting surplus. While interest earnings from its foreign currency assets make up the largest part of the FEFSA’s income, the government simply re-invests these earnings into foreign assets, insisting that repatriating them would risk the yen’s appreciation.

Consequently, by the end of each year, revenue has already been transformed into new foreign currency assets, with no cash left for other purposes. Meanwhile, the government insists the FEFSA’s joyokin is a genuine profit and that it can be used accordingly. In order to appropriate this non-existent profit, the government forces the FEFSA to raise yen-denominated funds by issuing fresh FBs over and above what is necessary to roll over its existing FBs. Therefore, even in a year when no exchange market intervention is conducted, the FEFSA’s short-term debt grows by the amount of its revenue.

The current FEFSA system is financially unhealthy; it is absurd to cash in unrealised profits while ignoring unrealised losses. Moreover, even though the Japanese government formally maintains a policy of not incurring short-term debt to finance its regular expenditure, the FEFSA allows it to circumvent this self-imposed regulation.

The FEFSA is also dangerous because it gives the government a perverse incentive to pursue a socially undesirable exchange rate and reserve policy. The government can raise more short-term debt through the FEFSA by increasing the latter’s accounting profits. This can be done by increasing the stock of its foreign currency assets and/or by raising the average return on these assets. The former can be done by performing more exchange market interventions, which, if successful, has the additional benefit of depreciating the yen and pleasing Japanese exporters. The latter can be achieved by expanding the FEFSA’s portfolio to include less-liquid and longer-dated assets, although doing so inevitably means incurring more financial risk. But, with falling returns on US and other sovereign bonds, the Ministry of Finance is now desperate to stop the FEFSA’s revenue from shrinking further.

It is obvious that current practices cannot continue forever. Under existing accounting rules, the FEFSA’s short-term liabilities can grow without any limit, but this is incompatible with the growth prospects of the Japanese economy. It is time for the Japanese government to stop engaging creative accounting and start making serious efforts to put its fiscal house in order.

By Masanaga Kumakura Professor at the Graduate School of Economics, Osaka City University. East Asia Forum