The fall of the U.S. dollar is creating dilemmas and portending change around the world. Much has been made of China’s dollar peg, but the greatest challenge, with the most potential global impact, is that of Japan. No country has supported the dollar more steadfastly than Japan, with the Bank of Japan by far the largest foreign holder of U.S. treasury bills. Buttressing the dollar has ensured a cheaper yen, but more than that, it has cemented Japan’s support for American global leadership. With each decline in the dollar (and increase in the yen) there is renewed concern in Japan that the yen will eventually reach a tipping point, beyond which Japanese exports will lose their competitiveness. Yet, there are good reasons to doubt whether Japan can export its way out of its economic crisis. For such prodigious support for the dollar also comes with mounting domestic costs that can no longer be ignored. Japanese bureaucratic elites are thus trapped between the rock of a potentially rising yen and falling exports, and the hard place of the mounting costs of their obdurate defence of the “global” currency.

Today, Japan sits on an accumulated hoard of more than $800 billion, the fruits of more than two decades of current account surpluses. Most of these funds are held directly by the Japanese government, and 90 per cent are kept in U.S. treasury securities. Japan and the United States are unwittingly locked in a self-sustaining embrace whereby Japan leaves its surplus inside the U.S. financial system in exchange for the U.S. government tolerating permanent trade deficits and an artificially low yen. Each time this arrangement has come close to unravelling over the past decade, both sides have opted for continuity over adjustment.

Japan: A Growing Dollar Reserve

Japan’s economic bureaucracy has been able to maintain its obsession with running external surpluses, continuing to hope that Japan will eventually export its way out of its decade-long economic and social stagnation, while discouraging the purchase of cheaper imports in the world’s highest-cost country. The idea that a cheaper yen will facilitate an export-led solution may be deeply embedded in Japan, but a decade of suppressing the yen and steadily increasing dollar surpluses has come nowhere near yielding such a result. It is doubtful that there is sufficient global demand to actually absorb the significant increase in Japanese exports that an export-led turnaround would require.

As long as Japan’s surpluses remain in dollar-denominated assets and monetary authorities cannot create their yen equivalents inside the domestic financial system by monetary stimulation, the surplus will continue to constitute a huge deflationary drain of resources out of Japan’s financial system with significant opportunity costs. If used creatively, these funds could help underpin wide-ranging reform that would facilitate the recapitalization of ailing regional banks or the elimination of local government debt as a prelude to greater local autonomy, a popular measure necessary to break up Japan’s over-centralized state. They may also be used to bolster domestic consumer spending, which has plummeted since the late 1990s, something much more likely to have a stimulative impact than increased exports. Japan’s dollar reserves have been compensated for with fiscal spending on wasteful, ecologically damaging public works that have driven up public debt to politically contentious levels and redistributed wealth in the direction of the ruling Liberal Democratic Party’s key support groups.

Successive U.S. administrations have become dependent on this large pool of foreign-held dollars. It has made a generation-long deficit seem cost-free, permitting Americans to over-consume and fall deeper into debt without feeling the pressure to reduce imports or undergo the kind of restructuring that the U.S. government regularly urges upon other countries. Foreign money has also indirectly contributed to low interest rates and inflated asset prices, while lessening the consequences of financing tax cuts and foreign war in the face of enormous budget deficits.

The Central Banks Support the Dollar

The support exhibited by prominent Asian and European central bankers for the dollar is a clear indication that a speculative run on the dollar is not in their perceived interests. The Bush Administration interprets this foreign support for the dollar as an acknowledgement of America’s underlying economic strength. Yet, the mounting concern for how the Bush Administration is managing its deficit is pulling in the opposite direction. Unless it abandons some of its key domestic- policy priorities, something that appears doubtful, there is little likelihood that the U.S. will make the adjustments required to inspire confidence in foreign investors to continue their unambiguous support for the dollar’s safe-haven currency status.

The prospects of a prolonged decline in the U.S. dollar, be it precipitous or incremental, means that, even on its own terms, Japan’s support for the dollar is likely to prove futile.

Yet, faced with the recent dollar decline, for example, the Japanese government has, true to form, attempted to counter the fall by aggressively buying dollars and doubling its investment in U.S. Treasury Bonds over the course of 2003-04. Furthermore, Watanabe Hiroshi, the finance official in charge of international affairs, recently indicated that further dollar declines would precipitate additional interventions by the Bank of Japan. Despite the official line, however, there are a growing number of reasons why Japan should consider abandoning its current level of support for the dollar. Moreover, there are also increasingly compelling reasons why the current context may offer propitious timing for such change.

What If the Dollar Collapses?

Any dramatic fall in the dollar would literally wipe billions off the value of dollar assets held by Japanese and other foreign investors. While this is not of paramount importance to Japan’s monetary officials, it is a factor they are increasingly being forced to consider. Any steep decline in the dollar would prompt monetary authorities in countries like China and Russia to diversify out of dollars, just as they did in late 2004, thereby undermining Japanese leverage to control the value of the yen.

Japanese businesses are now hedging against exchange rate volatility by denominating their non-North American trade in euros, or, in the case of China and the rest of East Asia, in yen. Increases in the yen against the dollar at the end of 2004 were somewhat offset by an overall retrenchment against other major currencies. However, once China abandons its dollar peg, a majority of Japan’s trade will be decoupled from the yen-dollar rate, thereby undermining the export-supporting rationale for maintaining Japan’s large pool of dollars.

The increasing prominence of the euro further complicates Japan’s dilemma. The euro may still not function as a full-fledged reserve currency, but the continued expansion of its use complicates matters for Japan, as European monetary authorities have no political stake in supporting a low yen.

It is curious that, in a country piling up huge surpluses, with glaring social needs, a plethora of ailing banks and contested public indebtedness, there are virtually no voices questioning why the $825-billion accumulated surplus is being used exclusively to support the dollar and what the opportunity costs of that policy might be. The compelling reasons why Japan should change its dollar policy invariably confront the ideological and material forces that underpin continued dollar support. For ultimately, it is the political costs of unwinding such support that make it unlikely.

Domestically Prime Minister Koizumi, trying to salvage what he can of his largely discredited reform program, increasingly relies upon an alliance with a resurgent Finance Ministry, intent on re-entrenching its power and restoring fiscal probity with a minimum of real reform. Internationally, in a region where neighbouring countries are moving ever closer to China, Koizumi has chosen to accede to almost all American demands, dispatching Japanese forces to Afghanistan and Iraq, sharing Washington’s hard line on North Korea and presiding over Japan’s increased integration with the U.S. military. Support for the dollar may just be one more of the new costs that Japan has to bear to remain an affluent dependency of the U.S. in the twenty-first century.

Mitchell Bernard is an independent researcher on Japan and East Asia. He lives in Toronto and teaches regularly at Japanese universities.

Is a Dollar Collapse Imminent?

At an estimated $670 billion, or 5.7% of gross domestic product (GDP), the U.S. current account deficit is the largest ever. An already huge trade deficit made worse by high oil prices along with a gaping federal government budget deficit (Iraq plus tax cuts), have helped push the U.S. current account deficit into unchartered territory. The last time it was over 4% of GDP was in 1816.

With export earnings covering only half the cost of imports, the difference is made up by exporting U.S. greenbacks. These end up as dollar reserves which, in turn, foreigners invest in the U.S. by aquiring corporate stock or lending the money to corporations and governments. It all appears to work out with U.S. consumer demand propping up global trade and employment (American trade deficits are Asia’s and Canada’s trade surpluses); and foreign investors using their dollar holdings to cover the U.S. current account deficit.

But what happens if foreign investors decide they have sufficient or excessive amounts of dollar denominated assets? This can occur as they hold more of them and as the threat of a falling dollar reduces their worth. Compared to early 2002, the dollar has already dropped 23% against the yen, 25% against the Canadian dollar and 38% against the Euro. London’s Economist warns that “if the dollar falls by another 30%, as some predict, it would amount to the biggest default in history: not a conventional default on debt service, but default by stealth, wiping trillions off the value of foreigners’ dollar assets.”

This could easily become a self-fulfilling reality, for should foreign investors stop buying U.S. securities, the dollar will crash, stock values plummet with a world-wide economic downturn sure to follow. Even if foreigners continue to purchase U.S. bonds and stocks, the U.S. Federal Reserve Board will have to boost interest rates to compensate investors for their lost value as the dollar slips in value. This would still result in a downturn, albeit a more gentle one.

What are the Chances of this Disaster Scenario Happening?

Nobody knows. So far foreign investors have been happy to continue to purchase debt issued by corporate America and the U.S Treasury to cover the current account deficit. But even Alan Greenspan, chair of the U.S. Federal Reserve, has warned that foreign investors are likely to realize that they have put too many eggs in the dollar basket and will either unload their dollar-denominated investments or demand higher interest rates.

In the meantime, as currencies around the world are pushed up relative to the U.S. dollar, current account balances are starting to hurt in many countries . For countries like Canada that are so heavily dependent on exports to the U.S., stagnant growth could easily result as manufacturers find it increasingly difficult to sell abroad and to protect their markets from U.S. producers and U.S.-dollar pegged economies like China and South Korea.

Sources: Cy Gonick, John Miller in Dollars and Sense (Jan/Feb, 2005); Robert Samuelson in Newsweek (March 21, 2005)

This article appeared in the May/June 2005 issue of Canadian Dimension .