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Japan’s foreign reserves pass the $1 trillion mark; Sovereign wealth fund?

Earlier today, the Ministry of Finance announced that the value of Japan’s foreign reserve holdings had increased for the ninth straight month in February, and had exceeded $1 trillion for the first time. Holdings increased by $11.94 billion, hitting a total of $1.01 trillion. February was the eighth straight month in which foreign reserves hit an all-time high.

The nation’s foreign currency reserves stood at $979.2 million as of February 29, with $856.8 million of that in securities. $23.90 billion was reported in gold holdings, up by about $1.2 billion from a month ago.

Over the past 15 months, the Ministry of Finance has used about 35 trillion yen, mainly to buy US Treasury securities in an attempt to stem the decline of the value of the dollar. Japan is the world’s largest holder of US Treasuries.

The obvious question now is whether the passing of the $1 trillion mark will lead to increased calls for Japan to shift from its current system of holdings to a strategy that includes a sovereign wealth fund. Bloomberg quotes Masamichi Adachi, an economist at JPMorgan Securities in Tokyo, as saying:

A trillion dollars is a big number, so people are likely to think the government should put that money to better use. Unlike in China, the Middle East or Singapore, Japan’s foreign reserves are backed by debt, so the risks involved in a sovereign wealth fund would be much greater.

However, even if the sovereign wealth fund path is chosen, it’s not going to happen for some time yet. The ruling Liberal Democratic Party set up a panel to discuss the possibility of establishing such a fund last month, and it met for the first time on February 22. It’s goal is to write a bill in April, submit it to the diet this fall, and have it enacted sometime early in 2009.

Arguments for a sovereign wealth fund are plenty, though the most urgent sounding came from comments made by panel member and LDP Upper House lawmaker Kotaro Tamura in the Yomiuri this week:

The world financial market has been hurt by the subprime mortgage crisis in the United States. If we had a fund at this time we would have the opportunity to purchase overseas assets at advantageous prices and to sell them at a profit.

Tamura, of course, must be aware of his own panel’s timeline. Could Japan set up an SWF in time to catch the bargains? Or will they be forced to settle for leftover fukubukuro, at least until the next US financial meltdown hits?

Still, the Yomiuri piece hints that other risks remain, foremost among them the possibility that shifting assets away from Treasury holdings and into equities might cause a further decline in the value of the dollar. Could asset diversification by the Japanese government contribute to a further decline in the value of the dollar?¹ We are not completely sold on that one, at least not until someone with a crystal ball shows a certain future decline in the value of the dollar and can prove a connection to Japan’s downsizing its Treasury-backed holdings. In other words, evaluating potential consequences (ie, risk management) still very much falls in the realm of educated guesswork when it comes to this matter.

One thing is for sure, the current strategy of issuing yen-denominated debt in order to fund the buying of more and more US Treasuries in an attempt to bolster the value of the dollar is not working, and it probably never will work; if it did work, we would probably have a dangerous bubble on our hands anyway. History fails to lie: Ministry of Finance attempts to prop up the dollar in early 2004 by openly intervening in forex markets largely failed (On January 1, 2004, the yen was at 104.40 against the dollar. Ninety days later, on April 1st, just after three months currency manipulation carried out by selling 14.8 trillion yen ended, the rate was 104.40 - no move).

Another interesting argument against the creation of a sovereign wealth fund comes from Economic analyst Hajime Yamazaki (not to be confused with the actor of the same name), who feels the establishment of an SWF would go against the principle of structural reform and privatization. That principle is worded by the LDP as an attempt “to put in the hands of the private sector whatever could be done by the private sector.”

But does that include the management of foreign reserves?

¹ Those of you who feel a further decline in the value of the dollar is inevitable no matter what Japan does with its dollar-backed debt holdings, feel free to fire away.

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