Discussion Paper Series 2009-E-15

Did the Structure of Trade and Foreign Debt Affect Reserve Currency Composition?Evidence from Interwar Japan

Mariko Hatase, Mari Ohnuki

Historical experience is often invoked in the modern debate on competition among reserve currencies, yet little is known about quantitative aspects or institutional features of reserve management. By drawing on newly obtained data on foreign exchange reserves, especially those broken down by currency, this paper explores the competition between the British pound sterling and the U.S. dollar for the status of leading reserve currency in Japan during the interwar period. We find that competition between these two currencies remained undecided and that their relative status alternated repeatedly. Historical materials and the results of econometric analysis suggest that the key factors explaining a choice of reserve currencies are trade volumes and the currency denomination of external debt. The latter criteria supported maintaining sterling's status as a reserve currency for the interwar period, reflecting its considerable share in debt service generated through issues that had been launched when London was the sole international market. The stability of potential reserve currencies is shown to be crucial as well. We also find evidence of institutional factors, which include taxation, foreign exchange controls, and restrictions on financial activities.

Keywords: Foreign Exchange Reserves; Gold Exchange Standard; Exchange Rate; Trade Strucutre; Debt Structure; Japan

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2009 Bank of Japan All Rights Reserved.

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