THE world of foreign exchange tends to get very tricky when central bankers start getting worried about the strength or weakness of their currency. This is the position in which the Bank of Japan (BOJ) now finds itself after the yen surged to multi-year highs of ¥84 to the dollar.
It has to decide whether to act to stem the yen’s rise after a slowdown in growth and months of deflation (see chart) are being exacerbated by a strong currency. But the jury is out on whether intervention is really effective. So which way should the central bank turn?
Yesterday’s decision to introduce a fiscal stimulus did little to dampen down the strength of the currency.
But Bank of New York Mellon’s Neil Mellor says the BOJ will be wary of any intervention after the Swiss National Bank (SNB) tried to reduce the value of the Swiss franc earlier this year. After a successful intervention in 2009, the SNB then tried to halt the franc’s rise against the euro at the height of the European sovereign debt crisis. It spent SFr30.4bn in the first quarter of the year and then a further SFr101.5bn in the second quarter, the peak of the European debt crisis. The downward pressure on the euro was too strong and the SNB was criticised for spending huge sums with only limited success.
LIMITS TO INTERVENTION
Intervention can be expensive and might only have short-term effects. But this may not be the only reason why the BOJ will avoid stepping directly into the markets. Commerzbank has calculated that a strong yen is putting downward pressure on prices and estimates that it has caused 0.7 percentage points of deflation since the start of the year. This would have most central bankers in a huge panic, since deflation is usually seen as a by-word for an entrenched period of slow economic growth. But not the BOJ, says Commerzbank’s Ulrich Leuchtmann: “They will always err on the side of deflation. The reason why they are being hesitant to act this time is that it creates yen liquidity. If that creates inflation then they will have to raise interest rates, which would be a problem.”
Leuchtmann says that higher interest are an issue in Japan because of its massive public
debt burden, which is already twice the size of the country’s annual output. “Higher interest rates could trigger a rise in Japanese Government Bond (JGB) yields and this will make it more expensive for the government to fund,” he adds.
But Mellor argues that verbal intervention – what the Japanese authorities have resorted to so far in their attempts to thwart the yen’s rise – only has a limited shelf life. “You can’t just cry wolf, you have to back the policy up with something more concrete,” he says.
The real issue with the dollar-yen exchange rate is the narrowing yield differential between US Treasuries and JGB’s. While the Federal Reserve remains committed to keeping interest rates at record low levels to stimulate the US economy, the BOJ could find it difficult to stand in the way of further yen strength.