Understanding the True Meaning of Foreign Reserves

Japan's foreign reserves are currently at a record high of $10.08 billion (approximately 106 trillion yen). Exceeding $1 trillion places Japan second in the world, after China. What's crucial to understand here is the precise meaning of foreign reserves. It becomes clearer when expressed in English.
They are called "foreign currency reserves." Reserve means to hold or keep. Therefore, calling them "foreign currency holdings" is more approachable. "Foreign currency" is mostly the US dollar. More specifically, they are held by the Japanese government and the Bank of Japan in the form of U.S. Treasury securities. These are public assets. A portion also includes euros (European currency) and gold bullion.

Foreign reserves are used by a nation for external payments, such as settling import bills and repaying foreign debt. The primary reason for the dramatic increase in foreign reserves (foreign currency holdings) is the repeated yen-selling and dollar-buying interventions by the government and the Bank of Japan to curb the past yen appreciation trend. In essence, because a strong yen would deal a blow to Japan's export-driven economy, they continued so-called BOJ interventions to maintain a weak yen. Particularly from 2003 to the spring of 2004, a massive sum of approximately 35 trillion yen was invested. Using the state power of BOJ intervention, they went all out to maintain a weak yen.
However, as the current exchange rate around 100 yen to the dollar shows, it's impossible for a single nation's power to maintain exchange rates determined by the global market for long. This clearly demonstrates the limitations of BOJ intervention. There have been no market interventions in the last two to three years. To be precise, there have been no interventions since March 2004.

Why Are Excessive Foreign Holdings a Problem?

Accumulating enough foreign currency to have absolutely no concerns about external payments is certainly not a bad thing, and it does enhance Japan's international creditworthiness. It clearly acts as a positive factor. However, as with all economic phenomena, there is no light without shadow. Positive and negative aspects coexist. Massive foreign reserves (foreign currency holdings) carry significant risks. If the exchange rate shifts towards a stronger yen and a weaker dollar, substantial losses can occur. Predicting the movement of exchange rates is more difficult than predicting stock prices. If we assume there is no risk, it would mean the weak yen level continues indefinitely, which is not a realistic expectation. The foreign exchange market is a more volatile world than the stock market.

Accompanied by Equivalent National Debt

Another point that cannot be overlooked is that foreign reserves are accompanied by an equivalent amount of debt. In fact, the funds for BOJ interventions to maintain a weak yen are prepared by issuing "short-term government securities." These are IOUs issued by the government to procure bridging funds. They are set to mature within one year. Essentially, they can be considered similar to short-term government bonds. The government primarily borrows from private financial institutions. While the interest rates are low, private banks fully cooperate because these are IOUs with the government's repayment guarantee. It could be said that there is a symbiotic relationship between the government and banks. In other words, the government bears an almost equivalent amount of yen-denominated debt for its foreign reserves.

The Relationship Between Foreign Reserves and National Finances

The paradox of massive foreign reserves is that since they are invested almost entirely in U.S. Treasury securities, and due to the Japan-U.S. alliance, they cannot be sold even if desired. If Japan were to sell a large quantity of its U.S. Treasury holdings, U.S. Treasury prices would undoubtedly plummet. This would rapidly lead to a stronger yen and a weaker dollar, essentially shooting oneself in the foot. For these reasons, it is difficult to reduce the accumulated foreign reserves. There is a situation where they cannot be sold even if one wants to. It's a predicament.
For reference, developed countries do not hold large amounts of foreign reserves. Compared to Japan's level, they hold a quarter or a fifth, an incomparable amount. The underlying reason is their focus on the increased exchange rate risk that comes with increased foreign currency. On the other hand, Southeast Asian countries, perhaps due to their painful experiences with foreign currency shortages during the 1997 Asian financial crisis, are keen on accumulating foreign reserves. What we need to be mindful of is that when the dollar weakens, meaning the yen strengthens, the value of assets converted to yen terms will drastically decrease. Another point not to forget is that foreign reserves are accompanied by nearly equivalent national debt. As government short-term securities, which are government IOUs, increase, it directly leads to a deterioration of our nation's financial health. Let's pay attention to the flow of foreign reserves while understanding these points.