Huge Dollar Reserves Prod Japan to Invest Abroad

The sheer size of Japan's foreign reserves is driving calls for creation of a sovereign wealth fund, similar to the Asian and Arab oil funds that have already put billions in faltering U.S. investment banks. The country’s reserves, which include foreign currency-denominated debt, bank deposits, gold and International Monetary Fund special drawing rights, now stand at a record $1.01 trillion.

Since much is in the U.S. dollar and losing value, pressure is on to earn more of a return.

"A trillion dollars is a big number, so people are likely to think the government should put that money to better use,” JPMorgan Securities analyst Masamichi Adachi told Bloomberg.

However, it’s not quite as simple as buying up shares in Citigroup, which sure could use the help, Adachi noted.

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"Unlike in China, Japan’s foreign reserves are backed by debt, so the risks involved in a sovereign wealth fund would be much greater,” he said.

Last month the ruling Liberal Democratic party formed a group to discuss creating a fund to manage $39 billion of interest and profits earned from the foreign reserves, plus $1.46 trillion in pension reserves.

"It's necessary to review the size of foreign reserves Japan should hold,” panel member Kotaro Tamura observes.

"When there's a growing risk that the dollar will tumble further, it's questionable that holding a large portion of dollar assets in the reserves will benefit to the nation.”

However, Japan may encounter more difficulties in establishing a fund compared to other Asian nations have because Japan’s reserves were created by selling trillions of yen of government bills – instead of from export cash inflows.

It may not be able to use the reserves to pare its public debt, which is now the world's largest, without selling some dollar-denominated assets — a move that could disrupt currency markets.

Simply establishing a sovereign wealth fund won’t change the fact that Japan can't sell dollar assets. In fact, Vice Finance Minister Hiroki Tsuda has said that should the country establish one, it may need to rely on borrowed money for investment capital.

"There's no easy way to solve the dilemma,” comments senior economist and former central bank official Hideo Kumano. Overall, indications are that the finance ministry wants to focus on liquidity, keeping reserves safe in case Japan needs to intervene in the currency market.

But the government has already issued financing bills that use some of the reserves’ profits, selling the bills to roll over debt that was used to sell yen until 2004.

The country’s reserves have increased dramatically five times in the past 10 years because the country’s Ministry of Finance purchased U.S. Treasuries and other securities to contain gains in the yen.

It has more than doubled since 2003, when the Finance Ministry sold a record 20.4 trillion yen to stop a stronger currency from harming exporters. The ministry followed 2003 sales by selling 14.8 trillion yen in first quarter of 2004.

The U.S. Treasury Department reports that Japan was the largest holder of Treasuries at the end of last year, ahead of China and the U.K.

Japan’s foreign-exchange holdings have benefited from the bond rally driven by the subprime housing crisis, reaching a new record in each of the past eight months, when indexes show Treasuries returned more than 10 percent.

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