By David Veitch
In a Move Not Seen Since 2004, Japan Intervenes in the Foreign Exchange Market
On September 14, Naoto Kan’s victory over Ichiro Ozawa by a margin of 721 to 491 altered the political landscape of the Democratic Part of Japan (DPJ); more importantly, it shook a market with an estimated 3.2 trillion USD of daily turnover. Foreign exchange markets were quick to respond to the news; the yen strengthened to a fifteen-year high as Ozawa, a strong supporter of yen intervention, lost the DPJ leadership race.
Before the decision, markets were jittery on Ozawa’s outspoken position that Japan would have to act unilaterally to curb the yen’s recent gains. While Kan had not previously called for currency intervention, he had engaged in verbal jawboning, insisting that he was willing to act to soften the yen. In light of the yen’s strength, many were wondering if Kan would turn to currency intervention as a policy option.
The yen’s recent appreciation has been met with calls from Japan’s business community for the government to intervene. Year-to-date the yen has been on a tear - USD/JPY (how many yen it takes to buy one US dollar) has dropped from 92 to 83. Many factors have been cited as being behind the yen’s appreciation. Namely, the yen has been seen as a “safe-haven currency,” much like the Swiss franc.
This safe-haven status has been especially apparent in recent weeks, as worries about sovereign risk in Europe and a double dip in the US have led investors to shift assets out of euros and dollars and into yen. The “safe-haven” effect has been especially pertinent because in the past the yen was underowned due to Japan’s low interest rate; now that European and US yields are lower, the yen has become slightly more attractive. Further putting pressure on the yen, China has been purchasing Japanese Government Bonds (JGBs) in an attempt to diversify its foreign currency reserves.
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The strong yen has hurt Japanese exporters whose goods are now more expensive, and hence less competitive, than its export rivals such as South Korea. This has led to worries in Japan that firms will begin to relocate their operations offshore; in a recent survey of companies conducted by the government, it was found that 40% are considering moving their production or operation capacities offshore if the yen stays at the 85-86 level.
This puts at risk a key part of Japan’s economic recovery: its exporters. A strong yen makes imports less expensive for the Japanese, and if combined with low exports, it would soften Japanese economic growth. Additionally, cheaper imports for Japan, and a softening of commodity prices amidst economic uncertainty, threatens to worsen Japan’s deflationary position.
In the midst of such adverse effects, it is somewhat reasonable that Japan would resort to currency intervention. Market watchers had noted weeks ago that intervention was a very real possibility; in an August 18 note, DBS stated that “JPY intervention is not a zero probability risk,” and JPMorgan had stated that with Kan’s victory, the odds of intervention effectively doubled.
The Mechanics of Intervention
To understand Japan’s intervention in the currency markets, one must first examine what foreign exchange intervention is and how effective it has proven to be. It is first crucial to understand that like anything, the foreign exchange market is not perfect. It is possible for exchange rates to differ from fundamental values in the short term; when this happens, central banks step in to bring exchange rates in line with fundamentals.
Central banks do this by buying or selling foreign exchange on the open market. In Japan’s case, the Ministry of Finance used the Bank of Japan as its agent, to print yen and buy foreign currencies, thus weakening the yen. Historically, Japan has focused on buying USD and investing into Treasuries in order to protect exporter profits.
In the developed world, central banks rarely intervene in the forex market. When they do, the effectiveness can be determined by the sustainability of the target exchange rate, as well as the government’s economic policies. Intervention is not a substitute for astute policy, and will fail if its objective is counter to the prevailing effects of government policies. In terms of size, studies have shown that large infrequent interventions are more effective than a series of smaller, more frequent, interventions.
Interventions are sometimes compared to “leaning against the wind.” While they may slow a currency’s appreciation or depreciation, rarely are they able to change the prevailing direction of currencies, especially when a currency accurately reflects macroeconomic imbalances. Given the sheer size of the forex market, it is not hard to imagine why it is difficult for governments to exert much lasting influence over it.
Japan’s History of Intervention
Despite having been quiet over the past several years, Japan has intervened in the currency markets numerous times, namely when it felt that the yen was appreciating too rapidly. Past interventions have occurred in 76-78, 85-88, 92-96, and 98-04. Such moves by Japan were sometimes met with disdain from the United States, who accused the Japanese of manipulating their currency, and in essence subsidizing their exporters.
A Misguided Decision
A strong reason why Japan should not have intervened in the currency markets is that it has had to act unilaterally (without the support of other countries). This limits the effectiveness of the intervention, and means that any change in the exchange rate will likely be short-lived. The intervention will no doubt be met with resistance from both Europe and America, who both would like to see Asian countries import more.
Given the elephant in the room, China’s manipulation of the yuan, it would be impossible for the developed world to support Japan and at the same time criticize China for having done essentially the same thing. In intervening, Japan is isolating itself from the rest of the developed world.
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Japan’s decision to intervene, in the author’s humble opinion, is the incorrect one. The demand for safe-haven assets, such as the yen, is not likely to abate, given the current level of economic uncertainty (which in fact will most likely be exacerbated by this decision). Kan’s desire to show his decisiveness to his nation is politically savvy, yet economically unwise. It will only be a matter of time before Kan realizes the size of the foreign exchange market; that is, much larger than the Japanese government.
Disclosure: No positions
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