April 14, 2011

The edition of Foreign Exchange Insights posted on this site for March 18th began, “Using many arguments, analysts like to downplay the usefulness and effectiveness of currency market intervention whenever that policy tool is employed.”  Sure enough, blogger Adam Kritzer screened an article yesterday, entitled What’s next for the yen in which he observes the fact that the resources at the disposal of G7 governments to intervene are far outgunned by the $4 trillion daily volume of global foreign exchange markets. 

The Currency Thoughts posting of March 18th was written one day after the yen touched a record high of 76.25 per dollar and a week after the great east Japan earthquake.  Just before the quake and ensuing tsunami and nuclear reactor accident, the yen had been trading at roughly 83.3 per dollar, which is virtually the same level as now.  After initially plunging to JPY 76.25, the dollar recovered to highs of 81.49 in the week to March 25, 84.72 in the week of April 1, and 85.54 on April 7.  This week has seen risk aversion swell in response to several developments, including some worrisome news from the Fukushima nuclear facility.  That’s an unfriendly backdrop for yen-weakening carry trade activity, but its difficult to tell from one day to the next whether investors are in the mood of absorbing risk or inclined to seek safety.  Adam Kritzer’s piece leaves open the possibility that the yen could either decline or resume its rise from here and admits that the threat of intervention could be a deterrent to the latter scenario.

The key to whether currency market intervention proves effective or not lies in context of its usage and the tactics that policymakers are prepared to employ.  Forex intervention works best in highly speculative markets where currency prices are no longer well-supported by underlying economic and other fundamentals.  It’s no secret that currency trends tend to overshoot, and policymakers can capitalize on that property. 

The yen’s rise immediately after the quake was based on the experience after the Kobe earthquake of January 1995.  Investors remembered that the yen had soared over 20% against the dollar within three months of the Kobe Temblor.  After a natural disaster, infrastructure has to be rebuilt.  In the case of Japan, which normally is an exporter of capital, such a shock tipped the market balance in favor of the yen.  Theory and experience suggested the yen could advance sharply.  Moreover, the yen had already been well-bid for quite some time, grinding its way higher.  In the very early days, it even seemed that the Sendai quake in a comparatively low-populated area would be less damaging than the Kobe quake in a big city.  That perception has proven very mistaken.  Because of the radiation risk, this is the natural disaster that keeps on coming, and activity is headed for a big setback and will not be so quickly reversed as first thought

With hindsight, it was the perfect time to intervene.  G7 officials understood that and wasted little time intervening together for the first time since the euro was supported in September 2000.  That earlier operation was also well timed.  The euro had been depreciating pretty much non-stop since its inception in January 1999 but would set its all-time low of USD 0.8228 just one month later.  If governments intervened without any intelligence about economic trends or market conditions, intervention would often be poorly timed and ineffective.  But central banks and finance ministries have terrific channels of information, so the occurrence of intervention tends to align with circumstances when it is more likely to succeed than fail. 

Arguments that focus upon only the direct effect of currency intervention, that is how much firepower can be used relative to the size of the marketplace, miss the fact that intervention works mainly as a psychology-changing device, that is through indirect channels.  That’s why verbal intervention in the right context can be as, if not more, effective as actual central bank sales of currency.  Robert Rubin’s spring 1995 mantra of a-strong-dollar-is-in-the-United States’-best-interest is any excellent example of that phenomenon.  

While the highly complicated and uncertain present dynamics of the foreign exchange market obscures where the yen might be going from here, it needs to be understood that it is easier to resist currency strength than weakness.  Intervention with the first intent sells own currency.  In the second instance, by contrast, one is selling somebody else’s currency.  If a government is prepared to subordinate every other objective including domestic price stability to weaken its own currency, there is no excuse for failure.  Pump enough yen into the marketplace, and it will depreciate.  Those are the elementary rules of supply and demand.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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