Tokyo will not shift to a contentious currency policy

The yen has once again made a new postwar high against the dollar, rising to Y75.69 on Wednesday as Japanese exporters continue to repatriate their foreign currency earnings. The strong yen has prompted finance minister Jun Azumi to warn that the authorities are ready to take “decisive action” in the currency markets and that he has instructed the finance ministry to be prepared to act.

Investors should heed these warnings about intervention and not chase the yen higher. Yet Japanese policymakers are unlikely to follow Switzerland’s example and announce an explicit exchange rate target for the yen as some are predicting.

Since the credit crunch began in 2007, Japanese and Swiss officials have faced similar challenges in the currency markets. As central banks around the world started cutting interest rates, foreign exchange investors unwound carry trades funded in low-yielding, safe-haven yen and Swiss francs.

The global financial crisis of 2008, the Federal Reserve’s two rounds of quantitative easing since 2009 and the eurozone debt crisis from 2010 led to both currencies appreciating substantially further. As a result the Swiss franc rose from SFr1.68 against the euro in 2007 to a record high of SFr1.00 earlier this year, while the yen strengthened from Y125 against the dollar four years ago to Wednesday’s new high.

In order to counter surging exchange rates, the Swiss National Bank and the Bank of Japan both cut interest rates to zero and engaged in unilateral intervention in the currency markets. SNB sales of francs pushed Switzerland’s foreign exchange reserves up from $43bn in March 2009 to $220bn by the summer of 2010 while the BoJ sold yen in September 2010, in March this year after Japan’s earthquake, and again in August.

But with the Swiss franc continuing to surge, the SNB went a major step further last month and announced it would pursue an explicit exchange rate target for the franc, committing itself to selling unlimited amounts of domestic currency to prevent the euro from falling below SFr1.20.

So far the Swiss authorities have been successful in setting a floor for the euro/Swiss franc exchange rate. The SNB intervened in the currency markets to push the exchange rate up to SFr1.20 on September 6 when it made its announcement to shift to a formal exchange rate target. Since then the Swiss franc has remained weaker than its target level, allowing the central bank to avoid re-entering the currency markets. In contrast the yen has continued to strengthen, raising expectations that authorities in Tokyo will follow Switzerland and announce a minimum floor against the dollar, perhaps at 80.

Exchange rate policy in Japan is set by the Ministry of Finance with the Bank of Japan acting as the government’s agent in the currency markets. Officials in Tokyo are increasingly concerned that the strength of the yen will result in local companies relocating factories and jobs from Japan to more competitive destinations like the US. Thus foreign exchange investors should expect renewed intervention in the currency markets if the dollar keeps falling from its weak historic levels against the yen. But Japan is not Switzerland. Despite Tokyo’s desire to prevent yen strength, policymakers are unlikely to follow the Swiss and pursue an explicit exchange rate target for the yen.

First, the authorities in Switzerland only acted after the franc had reached record levels against both the euro and the dollar. In contrast the yen is not trading at extreme levels in real, trade-weighted terms.

Second, Switzerland represents a small economy of 8m people. Japan, on the other hand, has the third-largest economy in the world and is a member of the G7. Any move to target its exchange rate explicitly would attract intense criticism from North America and Europe, particularly as it would make it harder to press China to appreciate the renminbi at a faster pace.

Third, Japan has more policy options. Switzerland’s government and corporate bond markets are limited in size. Thus when the SNB pursues quantitative easing, it has little choice but to print money and buy foreign bonds, making the franc weaken. In contrast, Japan’s authorities can undertake quantitative easing by printing money and buying local government bonds as the Japanese government bond market totals a huge $7,000bn. They do not need to use the exchange rate to loosen monetary policy.

Japan’s greater policy scope suggests Tokyo will not shift to a politically contentious exchange rate target for the yen. Instead, Japanese policymakers are likely to continue to intervene periodically in the currency markets while undertaking further quantitative easing measures at home to curb the strength of the yen. Switzerland’s shift to announcing an explicit ceiling for its domestic currency seems a step too far for Japan.

Source: http://www.ft.com/intl/cms/s/0/ace44c10-fe31-11e0-bac4-00144feabdc0.html#axzz1cUcP5WLp