Currencies | Mar 22 2011
By Greg Peel
"We, the G7 Finance Ministers and central bank governors, discussed the recent dramatic events in Japan and were briefed by our Japanese colleagues on the current situation and the economic response put in place by the authorities.
“We express our solidarity with the Japanese people in these difficult times, our readiness to provide any needed cooperation and our confidence in the resilience if the Japanese economy and financial sector.
“In response to recent movements in the exchange rate of the yen associated with the tragic events in Japan, and at the request of the Japanese authorities, the authorities of the United States, the United Kingdom, Canada, and the European Central Bank will join Japan, on March 18, 2011, in concerted intervention in exchange markets. As we long have stated, excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will monitor exchange markets closely and cooperate as appropriate."
And with this note on Friday the G7 central banks achieved their stated objective, that of capping the recent surge in the yen. At times like these it is not always necessary to intervene directly but to simply relay the intention and let the market do the rest. No trader is going to “take on” the seven biggest economies in the world (not including China, which does not have a floating exchange rate).
It seems counter-intuitive that at a time when the economy of Japan is in dire straits and GDP growth severely threatened by the ramifications of the earthquake that the Japanese currency should rise. A currency's strength, in theory, should mirror relative economic strength. But the Japanese have always been solid savers and for the past twenty years their interest rates have been near zero, so saving for retirement, for example, requires the Japanese to invest offshore to provide any sort of fund growth through better returns. Australian bonds, at a much higher interest rate, are a popular choice. This is an example of the famous “yen carry trade”.
And it is not just Japanese retail investors who seek better returns. Japan is a major US creditor holding US$886bn of US Treasuries. Japanese investment funds and insurance funds all invest heavily offshore. Clearly those insurance companies are facing a big pay day and payments will need to be made in yen, which means selling out of investments in Australia, the US and elsewhere and bringing those funds back home. Such repatriation means selling the investment currency and buying yen. All across Japan, funds are being repatriated to provide the yen needed to meet the costs of economic loss and the impending clean up and reconstruction.
And thus the yen has been rising rapidly against the Aussie dollar and more importantly against the reserve currency. The yen had already been rising against the US dollar as a result of the Fed's QE2 program which devalues the dollar, and the Bank of Japan has already intervened recently to prevent Japanese exporters being priced out of the market. QE2 is in itself an intervention, so it's really been a case of quid pro quo. Across the globe, QE2 has been a source of rising commodity price inflation – a fact which the Fed chooses to deny but realistically is indifferent to given disinflationary forces at home – and then MENA unrest has exacerbated the problem in terms of the oil price.
Imagine a game of football (any code) in which opposing players are doing their utmost to see their own team win. This “game” continues until one player is seriously injured, at which point the game stops as all participants agree the injured player's well being has now become paramount. Prior to the Japanese earthquake, the US was implementing QE2 to encourage its own economic recovery, Japan was intervening in the yen and implementing its own form of QE in response, China was refusing to revalue its artificially undervalued currency while the US was printing money and the ECB has threatened to raise its cash rate to fight inflation despite the perilous state of smaller eurozone economies. It has been little more than a game in which there ultimately could be no winner. Exchange rates are, after all just relative measures. If one goes up another must go down.
Of course, the G7 have made it sound like they've now stopped the game to deal with a seriously injured Japan, but realistically the ramifications of Japan's economic woes spread to all global economic corners, impacting everything from aforementioned investments to the manufacture of much needed parts for the likes of everything from cars to i-Things. So there is still sufficient self interest here. What the global economy does not need so soon after the GFC is another major threat to financial markets through currency volatility. Financial markets remain quite fragile, two and a half years later.
The last time there was such a globally coordinated central bank currency intervention was indeed in the wake of the fall of Lehman, with even the Reserve Bank of Australia involved. Interventions are anathema to free market capitalists but even free market capitalists were happy when a financial meltdown was avoided in 2008. The G7 clearly now sees a new risk of sufficient magnitude to intervene once more, lest everything that's been achieved so far is sucked back out to sea in the tsunami's retreat.
“We have just witnessed one of the most clearly publicised and no doubt widely welcomed multi-lateral interventions in foreign exchange that I have witnessed in 25 years of scribbling about markets,” said ANZ head of technical analysis Tim Riddell in a note on Friday. Suggests Riddell, “it was widely assumed that authorities had no option to do otherwise”.
Japan, like the US, is so deeply mired in a budget deficit reflecting twenty years of mismanagement since the 1990 bubble-burst that it simply doesn't have the public sector capacity to cap the yen by itself. The Japanese government has also been in contact with corporates and insurance companies to ensure no mass repatriation which would send the yen soaring. Japanese households alone hold US$500bn of offshore investments, notes ANZ.
Markets knew the repatriation, and thus yen jump, was coming given that's exactly what happened in 1995 after the Kobe earthquake. But markets also appreciate that intervention to cap a currency does not always work. It didn't work for the Bank of Japan in late 2010, and nor did it work for the Swiss National Bank . The Swiss franc has recently become the world's safe haven currency of choice given the possibly unlimited propensity of the US to print fresh reserve currency, and the SNB's massive intervention last year has made no difference to the speed of a rising Swissy.
This time, however, a coordinated G7 has warned that the intervention on Friday (which did involve actual central bank transactions) is not a one-off. Multi-lateral interventions should be respected, suggests ANZ, as similar experiences in 1995 and 1998 (Asian currency crisis) in yen intervention indicate. Note the chart below.
A lot will rest on the evolving situation at the Fukushima nuclear reactor, notes Danske Bank, and the impact on global risk sentiment.
Danske suggests that if the intervention is successful, general risk appetite will be supported across the globe. This means the euro should push higher along with commodity currencies such as the Aussie and Brazilian real. Demand for the Swiss franc as a safe haven will only increase given the yen was previously also seen as a safe haven.
This adds up to a weaker US dollar, which in turn means higher commodity prices and global inflation. And the war in Libya, and the MENA situation in general, are hardly helping.
Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
