Capital Flow and Regulations on Capital Account Transactions During These Periods

After World War II and until the mid-1960s, Japan had imposed strict regulation on various overseas transactions under the old Foreign Exchange Control Law enacted in 1945. During this period almost no money flowed between Japan’s private sector and overseas markets. Japan joined the IMF and OECD in 1964 and terminated the regulation on current account transactions and gradually started to liberalize capital account transactions. The deregulation measures, taken on a rather ad hoc basis, were all incorporated into the new Foreign Exchange Law in 1980, which marked the turning point for the principle of Japan’s foreign exchange control from “to prohibit transactions” to “to make transactions free.”

In tandem with the deregulation of capital account transactions such as the domestic investors’ purchase of foreign securities and loosening of the upper limit on the ratio of foreign securities held to total assets, long-term capital flow expanded rapidly, especially after the 1980s. We can observe a couple of features in the development of Japan’s capital flow with foreign markets. First, the long-term capital account has continuously registered deficits (capital outflow financed by current account surplus). Second, if we look at the breakdown of long-term capital flow, while portfolio investment (investment in foreign securities) has been the largest item, foreign direct investment (FDI) has increased dramatically from the late 1980s. Third, while only portfolio investment showed a volatile fluctuation, the balance of other items, in particular FDI, continued to be deficits (Japan’s FDI far exceeds that of other countries in Japan.)

Regarding the relationship between the exchange rate system and regulation on capital account transactions, past lessons in various countries show that liberalizing capital transactions while maintaining an inflexible exchange rate system increases the risk of financial crisis. On the other hand, in the 1997–98 Asian financial crisis, countries with relatively closed capital transactions like the PRC and India were not so much affected by the crisis. In the case of Japan, the early 1970s, when the country moved toward a floating exchange rate system, coincide with the period when the liberalization on capital account transactions was underway.

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