Japan’s intervention in the currency markets on September 15 caused a moment of excitement not just among currency traders but also for those concerned about the country’s economic woes. The yen ended that week trading at over 85 to the dollar, having started below 83, so the government appeared to have achieved its short-term objective of weakening the currency.
But that wasn’t enough: a couple of weeks later the Bank of Japan brought back zero interest rates. This prompted IMF chief Dominique Strauss-Khan to warn of the pitfalls of competitive devaluations and the impact they may have on the global economy.
The BoJ’s theory, of course, is that a weaker yen will help the country’s exporters, whose sales have slumped at a time when Japan’s economy as a whole is suffering another prolonged bout of stagnation.
Yet many in Japan regard the currency intervention as doubly useless: it is unlikely to work and it is going about the problem in completely the wrong way. To begin with concerns about the efficacy of the intervention, it is first worth considering the scale of the BoJ’s initial success. On September 15, the rate stood at Y108/$. Secondly, in the weeks after this year’s intervention the yen crept back up to 84 against the dollar. Thirdly, as research from Nomura Research Institute’s Tetsuya Inoue indicates, the means by which the intervention was achieved threatens to undermine its success in the short term.
Inoue writes that the MOF intervened by using Japan’s yen reserves to buy dollars, a method that threatens to undermine the process because it will put pressure on the interest rate differentials between the two countries’ bonds. In other words, Japan will eventually have to invest most of the dollars acquired in the intervention in US treasuries, pushing UST lower, and given the historical correlation between the two countries’ two-year treasury spreads and the yen/dollar rate, that would imply a strengthening yen. To prevent these side-effects of intervention from achieving that contrary result, the intervention needs to be sterilized by mopping up excess funds from the market, a process that Inoue says could be achieved through treasury sales or FX swaps but which the US is unlikely to find attractive for cost reasons. In the longer run, however, Inoue argues that Japan’s continuing to effectively swap yen for US treasuries and thereby tighten rates could help the US economic recovery.
Away from these technicalities, the broader point is that currency interventions require counterparty cooperation to be really successful. If Inoue’s model holds, then the successful achievement of both countries’ objectives will require increased policy cooperation between the Federal Reserve and Japan’s government in the form of the finance ministry.
The longer-term problem is that tinkering with the exchange rate will not fix Japan’s economy, which has for too long relied on cheap availability of bank credit, the weak yen, an export-driven model and the subsidizing of companies by the household sector in the form of low interest rates on deposits. Domestic consumption must improve, say many local economists, and the country’s industries must consolidate and restructure. China has used a weak currency and an export-led growth model to send its economy into overdrive in the way Japan managed in previous decades; the latter country’s current predicament offers food for thought on the potential downsides of pursuing such a model unchecked.
