Did the structure of trade and foreign debt affect reserve currency composition? Evidence from interwar Japan

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 article explores the competition between the British pound sterling and the US 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.