Today’s Japanese Intervention: A Background Primer

September 15, 2010

The Bank of Japan sold yen against dollars on a persistent and very heavy basis today.  Over $10 billion equivalent were done and possibly as much as $20 billion.  The BOJ acted alone and as an agent for the Ministry of Finance, which made the decision to act after weeks of threatening such a recourse.  No other central bank intervened.  Joint G-7 intervention has not occurred since September 2000 when Bill Clinton was the U.S. president and the late Wim Duisenberg headed the ECB.  That last instance of cooperative intervention was undertaken to support the euro, which at the time was trading below $0.8800. 

Japan does not need the permission of other governments to intervene.  It is selling its own currency, so there is no constraint from the supply side.  Japan possesses $1.015 trillion of foreign exchange reserve holdings, $212 billion or 26.3% more than when it previously intervened on a unilateral basis.  Japanese officials implied that today’s and future intervention will not be sterilized, so the operation has the same impact on domestic money market liquidity as an outright sale of domestic government securities.  In buying dollars, the central bank creates yen that is left in the banking system.  The intent is to weaken the Japanese currency via a direct increase in the supply of that currency and indirectly by manipulating market expectations about the yen’s near-term prospects.  By telegraphing that the intervention will not be sterilized, officials hope to gain the market’s respect because investors have been trained to believe that sterilized intervention, whereby offsetting sales of domestic securities leave the stock of yen unchanged, never works more than very briefly.

Sterilizing intervention is not a sufficient condition for making the operation successful, however.  Intervention rarely stops a fundamentally-based currency movement before such has become excessive.  Yen fundamentals in recent times had appeared to support further appreciation.

  • Japan chronic current account surplus had widened as a percentage of GDP.
  • Japanese investors have little incentive to ship wealth abroad into assets denominated in other currencies.  Japanese interest rates are low, but so too now are U.S. and European rates.  In times of unusually high global and domestic uncertainty, the tendency is to keep wealth nearby.
  • Adjusted for inflation, the yen had not seemed pricey.  See my September 13 posting on Japanese competitiveness.

Japanese officials are also on delicate diplomatic ground.  Intervention risks straining relations with other governments.  A central principle of currency diplomacy is that while policy remedies ought to be customized to fit the circumstances of each country, the actions of one government mustn’t harm the circumstances of other nations.  Under that rule and insofar as external imbalances were a prime catalyst for a series of international financial crises culminating in the Great Recession, countries with current account surpluses like Japan have been instructed to stimulate domestic demand and to undertake other actions to promote a reduction of those surpluses.  China is the main object of such instructions but not the only one.  Depreciating the yen will tend to impede the eventual decline of Japan’s current account surplus, which reached a hefty 3.5% of GDP in the first half of 2010.

There have been moments when all major countries would benefit from a currency shift, but this is not one of them.  The Plaza Accord, co-signed by the Group of Five finance ministers almost 25 years ago on September 22, 1985, was one of those times.  But in 2010, every government wants a weaker currency.  In a globally disinflationary environment, nothing positive is gained from currency strength that enhances the possibility of importing deflation.  Advanced economies are suffering from deficient domestic demand.  Even in surprisingly buoyant Germany, domestic demand and overall growth crested last quarter.  Japan’s unilateral provocation to depreciate the yen violates a G-20 code of conduct not to strengthen oneself at the expense of others.

From the onset of floating exchange rates in 1973, the widest agreement within countries and between them on the use of FX intervention has been to counter currency rate volatility, or “disorderly market conditions” in the policymaker’s lexicon.  The pre-1971 Bretton Woods era of fixed dollar rates was all about achieving and maintaining a particular rate parity, but the current international monetary system assumes that market forces do the best job of finding parities that connect the supply and demand for currencies efficiently in the long run.  Intervention still has a role, but it’s more narrowly defined than before. 

Markets do not always march to a beat grounded in economic fundamentals.  FX movement can become increasingly one-sided and self-generated, with decisions based on the bandwagon psychology that an object in motion will continue on the same vector until an opposite and unlikely force is met.  In the early days of flexible exchange rates in the 1970’s, that kind of thinking tended to erode desirable market properties like depth, breadth, and resiliency.  In extreme cases, currency markets lost their basic intermediary function of matching buyers with sellers, and bid-ask spreads widened sharply.  When that happens, intervention could ensure a continuing presence of both buyers and sellers as forex quotes move, thus avoiding gapping price jumps in a vacuum.  Two other constructive functions of intervention would be to prod market players into reconsidering their expectations about future currency movements and to smooth out currency trends, truncating the amplitude of cycles at both their highs and lows.

Simple tests can determine whether intervention is conducted in the above spirit, regardless of what officials say to explain their action.  Intervention ought over the long run to be two-sided.  In Japan’s case, that has not been so.  When the dollar floated in March 1973, Japanese and French officials resisted the abandonment of the old regime the most.  It was a telling protest.  The paper trail of Japanese intervention over the last 20 years has likewise been one-sided.  Officials were quick to respond to yen strength but neglectfully accepted yen weakness. 

This is the legacy from feeling burned by the 1985 Plaza Accord after which Japan acceded to a sharp run-up in the yen.   A rise in Japanese reserves of over $700 billion between end-1992 and March 2004 reflected the fingerprints of heavy intervention sales of yen.  Prior to the Plaza Accord, the yen had been volatile but on the whole kept weak.  It’s central parity prior to 1971 was at 360 per dollar.  The currency was reset at 308 after the first dollar devaluation in late 1971.  Four years later in December 8, 1975, it clocked in at 307 per dollar, unchanged on balance.  Volatility followed, strengthening the yen to 176.7 in late October 1978, then back to 264/$ but April 1980, up to 198 in early 1981 and softer again to 279 in November 1982.  It was not much changed at 262/USD in late February 1985, representing a per annum climb of slightly less than 0.7% from its so-called Smithsonian setting in December 1971.

The yen underwent four major advances in the past 25 years of 116% from 262 per dollar in February 1985 to 121 at end-1987, 101% from 160.3 in early 1990 to 79.85 in April 1995, 45% from 147.6 in 1998 to 101.67 in 2005,  and 50% from 124.1 in June 2007 to 82.87 this morning.  Japanese officials have had a hand in cutting of the peaks but not the troughs.  In spite of a net 216% appreciation over the whole 25 years, large Japanese current account surpluses have been preserved.  Regrettably, real economic growth in Japan has averaged an anemic 0.9% per annum over the last twenty years, nonetheless.  Cutting to the chase, Japanese officials associate a stronger yen with the weakness of economic growth.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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