The sudden surge in the value of the yen to a new all-time high against the dollar is a new headache for the Japanese authorities, just at the moment when they did not need one. In the aftermath of the Kobe earthquake in 1995, the yen temporarily surged by almost 20 per cent against the dollar, and a repeat of that episode now would greatly add to deflationary pressures in the economy. Fortunately, however, the Bank of Japan should be in a position to stop this from happening, and other G7 economies will hopefully realise that this is one area where they can really help Japan. There may not be many occasions where co-ordinated foreign exchange intervention is the right thing to do, but this is certainly one of them.
As Lex has pointed out, although the 5 per cent overnight rise in the yen (now partially reversed) has taken the Japanese currency to an all-time extreme against the dollar, the currency is not at an extreme in real terms against the rest of world. This is because Japanese inflation has been running at least 2 per cent below the world average for many years, and of course the dollar itself has fallen against most other currencies. Therefore, as the graph below shows, the real value of J.P. Morgan’s effective yen exchange rate index, and the competitiveness of the manufacturing sector, is about at its long term average.
Recognising this, influential voices like Eisuke Sakakibara (who ran yen policy in the 1990s) have argued that the economy can easily withstand a period in which the yen moves below Y/$ 80. Certainly, Japan is better placed than it was in 1995 from that point of view. But deflationary pressures are now more entrenched, and there is no scope for cutting interest rates to offset currency strength. In 1995, short term rates entered the crisis at 1.75 per cent, which offered some scope for conventional monetary easing. This was indeed used, and the bond yield also fell by 2 per cent. None of these offsetting forces can be called in aid this time. So what can be done?
The Finance Ministry in Japan has said that “speculative activity” was behind yesterday’s sudden rise in the value of the yen. They have also said that repatriation of foreign assets by insurance companies has not been a significant factor. This last point seems plausible. Even in 1995, when such repatriation was widely blamed for the rise in the currency, subsequent data showed that it was only a very minor factor. And as several analysts have pointed out, foreign assets held by insurers are usually covered by foreign exchange hedging, so repatriation would not have any effect on the net demand for yen.
What about speculation? The trouble with this word is that it seems to point the finger at banks, hedge funds and other trading entities which do nothing other than take short term positions in financial markets. But, in fact, this need not be the only way, or even the main way, in which massive short term pressure can develop in the currency markets. Even a small move in the timing of foreign exchange transactions by the “genuine” players in the market (eg exporters and importers) can temporarily imbalance the flow of demand and supply, and produce sudden dislocations in the price. Probably a combination of all of these factors produced yesterday’s currency turbulence, and the problem now is that this process can become self-fulfilling, as it did in 1995.
This alone seems to provide a strong case in favour of direct intervention in the foreign exchange market by the Bank of Japan. In the past, the BoJ has been willing to intervene when it believes that fx markets are unstable, and particularly when they believe that the yen is moving in a direction which is contrary to that suggested by “economic fundamentals”. They have been much less willing to engage in the kind of open-ended intervention used by the Chinese to set the rate for the yuan for many years on end.
The present situation seems to meet the BoJ criteria. Markets are highly unstable, and a further rise in the yen directly contradicts the needs of an economy which is still in a deflationary trap, and is faced with a near term contractionary shock from the earthquake. Furthermore, the BoJ actively wants to inject liquidity into the money markets in order to ensure that there are no funding pressures in the financial system. Direct sales of yen in exchange for dollars have exactly that effect. In consequence, and somewhat unusually, foreign exchange intervention supports the desired direction of domestic monetary policy, rather than working against it. They may not be able to cut interest rates below zero, but they can intervene to inject liquidity instead.
The BoJ demonstrated as recently as last September that they were willing to intervene (albeit half-heartedly) to prevent the dollar from moving below Y83. The case for doing so now is much stronger than it was then. And, this time, the chances of success seem much greater, because the G7 should be willing to help. The international community may not be able to offer much help with the rescue operation, or with the nuclear crisis, but it certainly can help on the exchange rate. Unlike in the case of China, there is no reason to argue that the yen is chronically undervalued, or that the Japanese are engaging in “currency manipulation”. And there is every reason to view the current circumstances as entirely exceptional.
The French presidency of the G7 has scheduled a conference call on the situation at 7am on Friday morning (Tokyo time). I expect them to sanction some action.
