1. Introduction

The Council on Foreign Exchange and Other Transactions was assigned by the Minister of Finance at its plenary meeting on July 7, 1998, to investigate and deliberate on "the internationalization of the yen from the perspective of the ongoing changes in the economic and financial conditions in Japan and abroad." In response to this assignment, the Subcouncil on the Internationalization of the Yen (hereafter referred to as the Subcouncil) was created to deliberate on various issues and problems related to the internationalization of the yen from a practical and specialized perspective. To date, the Subcouncil has held seven meetings and engaged in active discussions, including the holding of various hearings.

This interim report reviews and outlines the various issues and problems related to the promotion of the internationalization of the yen which have thus far been discussed by the Subcouncil. This report is being published with the following purpose in mind. In view of the fact that the Subcouncil's discussions have covered an extensive range of subjects and fields, including finance, taxation and trade-related transactions, it is hoped that this report will be widely utilized in the discussions of persons active and responsible in these various fields, and, in turn, that these discussions will extend and deepen the future deliberations of the Subcouncil.

2. Discussion of the Current Significance of the Internationalization of the Yen

(1) The internationalization of the yen was discussed during the 1980s in tandem with the subject of the liberalization of the Japanese financial system. Subsequently, in March 1985, the Council on Foreign Exchange and Other Transactions submitted a report entitled "Internationalization of the Yen." While the fundamental definitions and conditions underlying the previous discussion remain applicable today, the Subcouncil has, in the course of its discussions, identified the following issues which lend current significance to the internationalization of the yen in view of recent economic and financial developments.

[1] One of the factors contributing to the Asian currency crises is said to have been the excessive dependence of Asian countries on the U.S. dollar. Promoting the internationalization of the yen is of particular significance at this time when Asian countries are moving away from virtually dollar-linked exchange regimes and looking for alternative systems. An increase in the use of the yen in Asia will contribute to stabilizing the exports and macroeconomic performance of these countries, which in the long-run will be conducive to the stability of the Japanese economy.

[2] The international monetary system will be entering a new phase with the introduction of the euro in January 1999. It is generally believed that the euro has the potential for functioning as a key currency of comparable stature to the U.S. dollar in the near future. With this prospect in mind, the promotion of the internationalization of the yen is essential given the importance of Japan in global economic activities. In addition, the internationalization of the yen can make a significant contribution to the risk diversification of the investments and fund management of international investors, central banks, and others.

[3] Cross-border transactions have been essentially liberalized under the revised Foreign Exchange Law which came into effect in April 1998, while progress is being made in reforming the Japanese financial system through the so-called "Big Bang." Against this background, improving the convenience of the yen in the financial and capital markets and, in particular, offering risk-free yen-denominated assets to non-residents can make significant contributions to improving the attractiveness of the Tokyo markets, while also heightening the effectiveness of the "Big Bang."

[4] In addition to the above benefits, the promotion of the internationalization of the yen can significantly contribute to reducing the foreign exchange risks of trade and capital transactions through the expansion of yen-denominated business. Especially for Japanese financial institutions, the internationalization of the yen can be expected to improve their competitiveness in the international financial markets. The first such advantage pertains to the BIS capital adequacy computations of Japanese financial institutions. With the growth of yen-denominated assets, capital adequacy levels will be less prone to be affected by exchange rate fluctuations. Secondly, Japanese financial institutions will be able to effectively reduce the availability risks of procuring foreign currency funds.

[5] In the past, various disadvantages of the internationalization of the yen were cited. These included the negative impact on Japan's export competitiveness resulting from the growing demand for the yen and the subsequent appreciation of the yen and restrictions on domestic monetary policies. Such views, however, are disappearing, while the significance of achieving the above-mentioned benefits has been growing.

(2) As indicated above, opinions emphasizing the significance and utility of the internationalization of the yen formed a clear majority in the deliberations and discussions of the Subcouncil. In addition, it was indicated that the effective promotion of the internationalization of the yen would be predicated on the following conditions: [1] Sound macroeconomic management. (Given the current economic situation in Japan, it is crucial that confidence in the Japanese economy itself be regained by rebuilding the financial system and restoring the economy to a path of stable growth.) [2] Stabilization of the value of the yen. [3] Improved convenience of the procurement and management of yen funds. The opinion was also voiced that the internationalization of the yen did not in itself represent a policy goal, but rather was something that would be realized subsequent to the improvement of the general environment of Japan's financial and capital markets. Furthermore, it was noted that improving the convenience of the yen would involve the active review and revamping of the current system by the government, as well as the introduction of various modifications and reforms on the part of the private sector. Hence, it was agreed that the promotion of the internationalization of the yen would require the active efforts of both the government and private sector.

(3) Based on the above considerations, the Subcouncil has focused its discussions on issues related to improving the convenience of the procurement and management of yen funds.
The principal elements of this discussion are summarized below.

3. Subcouncil's Principal Points of Discussion Regarding Specific Measures

(1) Issues Related to the Financial and Capital Markets

[1] Issues Discussed at the Subcouncil

Financial liberalization since the 1980s has resulted in the removal of a significant number of regulations and restrictions which previously existed in Japan's financial and capital markets. Improvements have also been made with regard to the tax system. For instance, market and tax rules have become more favorable for non-residents: The Tokyo offshore market has been created, past restrictions on the issuance and secondary markets for yen-denominated foreign bonds and Euro-yen bonds have been eased, and foreign corporations have been able for some time now to receive a full refund on withholding taxes for Treasury Bills (TBs) and Financing Bills (FBs) at the time of redemption. Nevertheless, ample room remains for further modifications in various areas which can effectively improve the convenience of the yen. The following points were discussed by members of the Subcouncil.

(a) In order to render Japan's financial and capital markets more attractive to foreign investors, it is necessary to achieve a level of market depth and infrastructure development which is at least on par with current levels in the U.S. and European markets. From the perspective of providing non-residents with risk-free and highly liquid financial products, and from the perspective of developing a benchmark function for all financial products, it is of particularly vital importance to improve Japan's market for short- and long-term government bonds.

(b) With regard to the short-term financial market: TBs and FBs constitute the principal instrument for short-term investment and fund management by non-residents including central banks because TBs and FBs offer reliability and liquidity and homogeneity as instruments. Particular attention should be paid to the following two points: [a] As compared to the U.S. market, there is a marked shortage of TBs and FBs in the Japanese market. Consequently, the market lacks adequate depth. [b] Due to special characteristics of TBs and FBs as financial instruments, taxes withheld at the time of issuance influence cash flows, which, in turn, might have the potential to affect price formation. In addition, investors in the Japanese market utilize repo transactions through cash-secured bond lending so that imposition of securities transaction taxes can be avoided. This practice is unique to Japan and steps must be taken to restructure the repo market along global standards. (Sale of securities with repurchase agreements are used in the European and U.S. markets.)

Note: Securities transaction taxes will be reviewed by the end of 1999, taking into consideration developments in financial system reform, trends in the market, and other factors and will be abolished together with the rationalization of taxation on capital gains derived from the alienation of securities and other instruments.

(c) With regard to the market for medium- and long-term government bonds: [a] Adequate liquidity is not necessarily available to match all the diverse forms of demand. Consequently, the markets are hampered from efficiently establishing a yield curve which can serve as an indicator for financial markets, which acts to restrict access to risk hedging measures. [b] Withholding taxes on the interest earnings received by non-residents may be one of the hindrances to non-resident participation in Japan's government bond markets.

(d) Significant improvements have been made with regard to settlement systems in recent years. Nevertheless, additional efforts must be made to develop market infrastructures to further encourage investment by non-resident investors. Such efforts should focus on establishing systems and transaction practices which conform to global standards and which support the precise and speedy delivery and exchange of funds and bonds. Particularly, with regard to the settlement system for government bonds, the creation and improvement of efficient secondary markets for government bonds based on global standards (e.g. book-entry system) must be further examined while paying due consideration to the opinions of market participants. In this connection, it was pointed out that over the medium to long terms, Japan should investigate modifications in its legal framework in light of the global standard for the delivery of securities in general.

[2] Specific Measures to Be Considered

(a) Specific measures for the short-term financial market: [a] Public auction of FBs. [b] Elimination of withholding taxes on TBs and FBs at the time of issuance.

(b) Specific measures for medium- to long-term government bond markets: [a] Diversification of available products [diversification of maturities and examination of the introduction of Separate Trading of Registered Interest and Principal of Securities (STRIPS), etc.]. [b] Exemption of non-residents from withholding taxes on interest arising from interest-bearing government bonds.

(c) In the review of the taxation system outlined above, measures to ensure equitable taxation, including procedures for identification of beneficiaries and information return, must be formulated while keeping in mind the proper overall balance of taxes on financial income so that revisions do not lead to tax evasion or capital flights. It is important that the review be performed with the intent of creating a simplified and appropriate framework using the central depository system--a secondary market system for government bonds based on global standards.

(d) Specific measures for the improvement of settlement systems: [a] Promoting the use of Delivery-versus-Payment (DVP) and Real-Time-Gross-Settlement (RTGS) Systems. [b] Shortening the settlement period. [c] Extending the operating hours of the Bank of Japan network (BOJ-NET). Additionally, with regard to business practices, it is desirable that private-sector discussion of practices and responses related to fail settlement be promoted.

(2) Issues Related to Trade and Capital Transactions

[1] Issues Discussed at the Subcouncil

In view of Japan's importance in the world economy, the ratio of yen-denominated settlements in Japan's trade and capital transactions remains low, for instance as compared to Germany. Moreover, there has been very little change in this ratio over the past decade. The expansion of yen-denominated transactions in current and capital accounts together with the above-mentioned improvements in the financial and capital markets constitute the two wheels on which any effort to promote the internationalization of the yen must ride. The following issues were cited as factors hampering the growth of yen-denominated transactions and settlements, etc.

(a) The currency used in invoices for trade transactions is determined by such factors as relative market power, the currencies in which international commodities are invoiced, and trade structures. Japan's yen-invoiced trade has not grown for the following main reasons: [a] Raw materials (most importantly, crude oil) invoiced in U.S. dollars in international trade, account for a large portion of Japan's total imports. [b] In intra-firm trade between Japanese parent companies and overseas subsidiaries, there is a tendency for parent companies to assume the foreign exchange risks.

(b) In addition to the above, the ratio of Japan's yen-invoiced trade with Asia--a region with which Japan has strong economic ties--remains low due to various factors. Specific problems include [a] the inadequate development of foreign exchange markets for the yen and Asian currencies (The yen suffers the effects of a vicious cycle in which the foreign exchange markets for the yen and Asian currencies are underdeveloped because of the low volume of yen-invoiced transactions, and in turn, the volume of yen-invoiced transactions remain low because of the absence of adequately developed foreign exchange markets.) and [b] the instability of the exchange rates between the yen and other Asian currencies because such currencies had heretofore been linked to the U.S. dollar.

(c) Yen-denominated overseas lendings of Japanese banks have not been growing for the following main reasons: [a] Overseas demand for yen funds is low in the first place because use of the yen in current account transactions has not spread. [b] Especially today, the credit risks of Asian corporations and financial institutions are growing and the Asian economy is experiencing recession. [c] Because of the development of dollar-yen forward and swap markets, it is generally considered that there are no longer significant limitations in conducting yen business in dollars.

(d) For yen-denominated transactions to be activated, yen balances held by non-residents must first be expanded. To achieve this, it is likely necessary to increase yen-denominated imports. Moreover, increasing yen-denominated assets in countries that hold yen-denominated debt from Japan can be expected to be significant in controlling currency mismatches between assets and debts.

(e) Asian countries are experiencing a serious credit crunch in trade finance as well, as a consequence of the economic difficulties which have followed the currency crises. Although trade finance has been supplied mainly in dollars heretofore, it is both desirable and necessary for Japan to respond to this credit crunch by expanding the available facilities for yen financing in the future. This course of action will also contribute to promoting the internationalization of the yen in the Asian region.

[2] Specific Measures to Be Considered

(a) Specific measures pertaining to trade transactions: [a] Expanding yen-denominated trade finance facilities. [b] Expanding Tokyo international commodities markets in order to provide greater opportunities for hedging yen-denominated transactions. [c] Developing a fuller awareness of the foreign exchange risks of trade transactions and reviewing current business practices pertaining to trade transactions.

(b) Achieving a higher ratio of yen-invoiced trade transactions can be expected to have a significant impact on the growth of yen-denominated capital transactions as it will increase the needs of both borrowers and lenders for yen. In addition, the following specific measures should be considered. [a] Developing a fuller awareness among Japanese financial institutions of the risks of doing business in foreign currencies. [b] Using guarantees and other kinds of support from the Export-Import Bank of Japan.

(3) Miscellaneous Issues

In July 1998, the Bank of Japan introduced yen repo services. In addition to this, it was suggested that the BOJ could further expand the scope of its yen-denominated facilities for foreign central banks and international organizations, while supplementing the services provided by the private sector. It was also suggested that the administrative authorities should take care not to burden non-residents with undue clerical costs when using the yen.

4. Future Deliberations of the Subcouncil

In its future meetings, the Subcouncil shall be discussing the above-mentioned issues in further detail. It will also be considering the recent changes in the international environment as they affect the yen, with particular attention to opinions in the Asian region to the internationalization of the yen, and current developments pertaining to the euro. The Subcouncil will schedule its deliberations in consideration of the fact that the Council on Foreign Exchange and Other Transactions intends to complete its assigned report for submission early next spring.

The issues mentioned in this interim report cover a very broad range of fields. Thus, the Subcouncil strongly hopes that persons concerned with the various fields covered will engage in thorough discussions of the issues mentioned herein and that they will without any delay launch their examination of appropriate measures to be taken along the lines of thought set forth by the Subcouncil.