Issues in foreign exchange policy in Japan : sterilized intervention, currency substitution and financial liberalization

Abstract

Three important issues for exchange rate management policy in Japan, sterilized intervention, currency substitution and financial liberalization, are discussed in this thesis. The analytic starting point for the analysis of these issues is the open economy portfolio balance model. The empirical importance of these three issues depends on three critical assumptions relating to: the degree of substitution between bonds denominated in different currencies (sterilized intervention); the degree of substitution between mODles denominated In different currenCIes ( currency su bstitu tion); and the stability of asset demand functions (financial liberalization). Three methods are used to investigate whether bonds denominated in dollars and yen are perfect substitutes. One method is based on a vector autoregression; the second is based on a demand function for yen-denominated bonds taken from a portfolio model; and the third is based on a 'market efficiency' model. For bonds of three-month maturity, the evidence is broadly consistent with the two types of bonds being imperfect substitutes. For bonds of one-month maturity, the evidence is rather ambiguous. Strong support for the portfolio model that suggests sterilized intervention will be effective is not found. Account was taken of the possibility that some of the major Japanese financial liberalizations influenced the degree of substitutability between bonds. Currency substitution is concerned with the degree to which mODles denominated In different currenCIes are substitutes for one another and are substitutes for bonds In different currenCIes. Evidence on this will assist In determining the importance of private sector switching between monies denominated in different currencies and switching between money denominated in one currency and bonds denominated in another. The appearance (or non-appearance) of foreign interest rates and the expected rate of change of the exchange rate in the domestic money demand function are two Issues that are of importance for currency substitution. Estimates from a number of money demand functions for yendenominated money suggest that currency substitution is not important for the yen even following a regulatory change in 1980 that might have been expected to increase the possibilities for currency substitution.Over the past ten years, a great deal of financial liberalization has occu rred In Japan. Much of the international pressure for Japanese liberalization has been motivated by a desire to achieve an appreciation of the yen. Some of the general arguments linking liberalization and the value of the yen are evaluated and it is concluded that, in the short-run, an appreciation of the yen is not a necessary consequence of financial liberalization. Some of the arguments suggested that a depreciation of the yen was a likely consequence. A number of recent regulatory changes in Japan are examined to determine what characteristics a regulatory change should incorporate if it is to impact on asset demands and the exchange rate.