TOWARDS A NEW ERA OF CURRENCY INTERVENTION / THE FINANCIAL TIMES MARKET INSIGHT ( HIGHLY RECOMMENDED READING )

Towards a new era of currency intervention

By Mansoor Mohi-Uddin

Published: September 22 2010 13:49

This month Japan’s authorities intervened in the currency markets for the first time since March 2004. The Bank of Japan, on behalf of the Ministry of Finance, sold yen and bought an estimated $20bn. This aggressive action pushed the dollar up from 15-year lows just below Y83 back to Y85.

Tokyo’s return to the currency markets has notable consequences for foreign exchange rates, Japan’s economic outlook and the coordination of international exchange rate policies. It also highlights how Japan’s post-bubble experience continues to provide a template for other advanced economies responding to the credit crunch.

The yen is no longer a one-way bet against the dollar. The authorities in Tokyo have encountered little overt criticism from Japan’s trading partners for their actions last week. As a result, the Bank of Japan is likely to return to the currency markets if the dollar falls back towards Y83-84.

As Japan’s authorities are acting to weaken rather than strengthen the yen, they can print unlimited amounts of domestic currency to do so. Theoretically, the only constraint they face is the risk of inflation. But with Japan’s economy still in the grip of deflation, the authorities have the ability and the incentive to prevent further gains in the yen. This matters at a time when the Federal Reserve is considering additional quantitative easing – a move that would put downward pressure on the dollar. Japan’s return to the currency markets now means the yen won’t be reflexively favoured by investors turning bearish on the greenback.

The decision by Japan’s authorities to sell yen alters the country’s economic policy mix at the margin. Ever since Japan’s great asset bubble burst at the end of the 1980s, the government and the central bank have been at loggerheads over how to respond. As the Bank of Japan is independent, the Finance Ministry has had little say over monetary policy. But as it, rather than the central bank is responsible for exchange rate policy, the Finance Ministry’s instruction to sell yen last week has effectively forced the Bank of Japan to print more money. That has encouraged stock investors. If Prime Minister Kan’s government pushes through further fiscal stimulus, then both monetary and fiscal policy will give a further boost to Japan’s economy.

However, the benefit to Japan’s economy comes at the cost of complicating international exchange rate policies. The G20 has been pushing China to appreciate the renminbi at a faster pace to help reduce large global trade imbalances. This month the authorities in Beijing have indeed allowed their own currency to rise more quickly. But Tokyo’s action blunts the message of the G20 to China, given that it enables Japan itself to continue running a large current account surplus.

While co-ordinated exchange rate policy may help deal with global economic imbalances, there seems to be little prospect of a grand bargain between America, China, Japan and Europe to undertake action akin to the Plaza Accord in 1985 to weaken the dollar. That would require currency appreciation in Asia against the US dollar and European currencies, a shift in underlying monetary policies to support stronger Asian currencies and changes in economic policies to bolster Asian consumption rather than exports in the long term. But in China, the Plaza Accord is viewed as having led to Japan’s great boom and bust; by reflating the economy to reduce the country’s trade surplus, the Japanese authorities cut interest rates, inadvertently stoking the huge bubble in the Nikkei at the end of the 1980s.

What Japan’s foreign exchange action does suggest, however, is that global currency markets are likely to experience significantly more episodes of intervention by major governments and central banks over the next decade. Foreign exchange volatility has risen since the credit crunch began. And with uncertainty about policymaking and growth increasing in the world’s key economies, exchange rates are likely to fluctuate sharply over the next few years.

Last year the Swiss National Bank began unilaterally intervening to counter the strength of the Swiss franc. Now the authorities in Japan have followed to stem the rise of the yen. In many ways the world’s major rich economies have been following Japan’s own post-bubble path during the last few years of the credit crunch.

Like Japan, interest rates in the US, Canada, UK, Switzerland and the eurozone have been slashed, fiscal deficits have rocketed, major banks have had to be bailed out, growth has been stubbornly low and deflation has remained a danger. Similarly, Japan’s renewed intervention in the currency markets is likely to be followed by the other major economies acting in time, when they too are faced with highly volatile exchange rates. Perhaps this is why Japan’s trading partners have not complained much about last week’s action.

Mansoor Mohi-Uddin is managing director of foreign exchange strategy at UBS

Copyright The Financial Times Limited 2010.