FINANCIAL TIMES

Lessons from the yen-dollar talks
By Matthew Goodman and Robert Fauver

22 May 2005

Amid the inexorably rising US trade deficit, Washington is crying foul about "unfair" currency practices by its major trading partners. The leading economies of east Asia are seen as the main culprits, accumulating large trade surpluses and stockpiles of foreign exchange reserves while maintaining exchange rates that appear by all economic measures to be considerably undervalued. If the US Treasury will not act to address these inequities, Congress has threatened to take the issue out of Treasury's hands.

Such was the situation confronting the Reagan administration in 1983 as complaints about Japanese trade and currency practices rose to fever pitch. Facing a similar challenge today over China, the Bush administration would do well to consider the Reagan Treasury's innovative approach to financial diplomacy.

In November 1983, Donald Regan, US Treasury secretary, and Noboru Takeshita, Japan's finance minister, issued a rare joint statement declaring that "open, liberal capital markets and the free movement of capital are important to the operation of an effectively functioning international monetary system". They agreed to establish a working group of senior officials on yen-dollar issues. The group met six times in early 1984 and handed a report to the ministers in May that year.

The stated rationale for these so-called "yen-dollar talks" was to promote liberalisation of Japan's capital markets and internationalisation of the yen. At the time, Japan's financial system was heavily bankcentric, interest rates were strictly controlled by the finance ministry, and markets for yen instruments were limited. Most important from a US perspective, the yen was considered to be substantially undervalued, giving Japan a perceived unfair advantage in trade.

Pulling these strands together, Treasury's strategy was to promote a stronger Japanese currency by deepening the market for yen instruments and making yen assets more attractive to foreign investors. No secret was made of this objective: in its May 1984 report, the Yen-Dollar Working Group noted that steps to internationalise the yen and liberalise Japan's capital markets would "lead to a stronger yen".

The report included far-reaching commitments by Japan, such as a timetable for liberalisation of interest rates, the introduction of funding instruments such as certificates of deposit and enhanced access for foreign financial institutions to Japanese capital markets. As intended, the yen-dollar process contributed to the yen's long-term appreciation from its postwar fixed rate of 360 yen to the dollar to roughly 105 yen today.

Financial conditions in China today in many ways parallel those in early-1980s Japan. China's currency, the renminbi, or yuan, as the local equivalent is known, is estimated to be undervalued by as much as 25-40 per cent. Moreover it is not convertible. Capital flows in and out of China are broadly government controlled. Most domestic financial transactions and prices are also heavily regulated, and the range of permitted financial instruments is limited. Domestic capital markets are embryonic, with minimal foreign participation.

Of course, China is not Japan. Apart from the specific differences in the two countries' exchange rate regimes - China maintains a rigid peg, Japan a "dirty float" - China is still a developing country, with per capita income at one-thirtieth the level of Japan's. China's economy is more open to foreign direct investment than Japan's was then (or is now). And, whereas Washington had considerable leverage over Tokyo via their security alliance, the Chinese are widely perceived to be less susceptible to gaiatsu (foreign pressure).

But the point is not to replicate the yen-dollar talks precisely. Clearly the agenda, format and public portrayal of any financial dialogue between the US and China would have to be modified substantially to reflect current bilateral realities. Among other things, a dialogue with China today should put more emphasis on promoting sound supervision of banks and better credit risk management. Provided the objective was to open and strengthen China's financial system and facilitate the move to a more flexible, market-based exchange rate, a dialogue that looked very different from the yen-dollar talks could make a valuable contribution to global economic growth and financial stability.

If presented as a bold, new initiative with senior-level involvement, such a dialogue could also make political sense for the Bush administration, helping deflect pressure for less market-friendly remedies to perceived unfair Chinese practices. There is even reason to believe it would be welcomed by Beijing, which may not like foreign pressure but has learned it is a reality of its new engagement in the global economy. China knows it could benefit from US experience and advice in tackling its serious financial inefficiencies, which jeopardise sustained growth.

The US Treasury has come under renewed domestic fire for failing to name China a currency "manipulator" in its latest report to Congress. Overt pressure - let alone the trade-restrictive remedies being contemplated on Capitol Hill - is unlikely to persuade Beijing to revalue its currency or fix its banks. In its wrangle with China, launching "yuan-dollar" talks could be exactly the kind of creative financial diplomacy Treasury used so effectively with Japan.

Matthew Goodman, U.S. Treasury Attaché in Tokyo 1992-97, is Vice President of Stonebridge International in Washington, DC and Robert Fauver, a former US Treasury staff director, is president of Fauver Associates.

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