The G-7 intervention to tame the surging yen (2)

Last Friday’s coordinated yen selling intervention, requested by Japanese Finance Minister Yoshihiko Noda, estimated at $25 billion by the Bank of Japan alone, seemed to work, with the yen depreciating from 79.50 yen to the US dollar, just before the G-7 announcement, to slightly above 81 yen. On Thursday the yen had soared in chaotic trading to 76.25 yen to the US dollar, its highest value against the US dollar since World War II. The yen had reached its previous record high at 79.75 yen to the US dollar in April 1995, three months after the Great Hanshin Earthquake, which had devastated the city of Kobe. Although they did not disclose the amounts of their yen sales or any target yen FX rate they might have agreed on, the intervention by all G-7 members also appeared to have a salutary effect on the Japanese and world stock markets, which reversed their steep falls recorded immediately after the Japanese earthquake and tsunami.

What caused the yen’s anomalous, seemingly counter-intuitive, sudden surge in the wake of the Great Tohoku Earthquake, similar to that witnessed in the wake of the Great Hanshin Earthquake in 1995? After all, one would have expected the yen, its international perception as a safe-haven currency notwithstanding, to fall, not rise, as the Japanese economy suffered great damage and the Bank of Japan immediately initiated a loose monetary policy through a massive quantitative easing for ample liquidity, close to a record 40 trillion yen, to prevent financial panic. The most common explanation is the repatriation of foreign assets by Japanese insurance companies to pay for the colossal damages. This explanation is rejected by many observers on the grounds that such repatriation was not imminent and the sums involved would have been dwarfed by the volume of transactions in the FX (foreign exchange) market. They also argue that most of the reconstruction costs would have be borne by the heavily indebted Japanese government and that its additional debt burden should be expected to push the yen down, not up. The spike in the yen’s value could have been caused by not only the speculators’ exaggerated and premature expectation of the repatriation of Japanese foreign assets by insurance and other companies but also the run for cover by hedge funds that had shorted the yen before the earthquake in light of Japan’s stagnant economy and rising huge public debt. Another contributing factor could have been the unwinding of carry trades by Japanese individual investors who are estimated to account for around 30 percent of yen trading. In yen carry trade, investors sell low-yielding Japanese assets for high-yielding but riskier foreign assets, practicing uncovered interest-rate arbitrage (see my column “Carry traders’ yen for the lira,” Feb. 26, 2007).

The consensus among international economists and currency traders is that aggressive and coordinated joint central bank interventions in the FX market can be effective in the short run to reduce excessive volatility, leaning against the wind, but not in the long run -- even when unsterilized to preserve their effects on national money supplies -- to maintain FX rates at or within predetermined levels. As for the yen’s effective real as well as nominal FX rate, the economic fundamentals point to a likely long-run sustained yen depreciation after its expected short-term appreciation fueled by repatriation in the months ahead of Japanese foreign investments, especially holdings of US Treasury securities estimated around $900 billion. This short-term appreciation would be tempered, however, by the Bank of Japan’s continued quantitative easing that could conceivably extend to monetizing the gaping government deficits resulting from huge emergency disaster relief and reconstruction spending programs.

There were already rumors last week that the Japanese government had plans to issue more than 10 trillion yen in earthquake restoration bonds and that the Bank of Japan would buy all of them, although such a purchase would be illegal under the current law. Even before the Great Tohoku Earthquake, which will definitely unleash massive deficit spending, monetized or not, Standard & Poor’s (S&P) in January cut Japan’s sovereign credit rating from AA to AA-, three levels below AAA, the highest possible rating, warning that the Japanese government had no “coherent strategy” to deal with its ballooning budget deficits. This was S&P’s first downgrade of Japanese public debt since 2002.

Currently 95 percent of Japan’s around 870 trillion yen government debt, more than 200 percent of GDP, is owned by its own citizens. Japan is a major international creditor nation, with a net external investment position close to 60 percent of its GDP. But rising future public indebtedness to foreigners, as Japan’s national savings pool contracts along with its aging population, could begin to nudge the yen downward in the years if not months ahead.