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Yen-tervention: When, How and Why Not Yet?
By Mikka Pineda
Update: The Bank of Japan (BoJ) resorted to further monetary easing on August 30, 2010, as an indirect way to weaken the yen. As RGE had expected, the BoJ increased its fixed-rate bank funding scheme (established in late 2009 to weaken the yen during the Dubai debt crisis) by JPY10 trillion to JPY30 trillion and also lengthened the term of loans provided to six months from three months. The BoJ took action before BoJ Governor Masaaki Shirakawa was originally scheduled to fly home from the Jackson Hole symposium, but markets quickly brushed off the move as monetary easing was already priced in. The yen continued to strengthen. With the BoJ remaining reluctant to intervene directly in the currency market, the Ministry of Finance (MoF) may take it upon itself to do so. To back up the BoJ's efforts, the government announced an "additional" stimulus package that, as RGE had expected, will be funded by leftover stimulus funds.
The widening disconnect between the yen and economic fundamentals has raised speculation that the BoJ will intervene directly in the currency market. The prime minister and MoF officials have made verbal interventions, but the yen persists in strengthening versus the U.S. dollar, ignoring the sharp slowdown in Japan's Q2 GDP growth and instead feeding off the Federal Reserve's escalation from “credit easing” to “quantitative easing.” Though export volumes have yet to fully reflect the impact of a strong yen, shrinking only slightly, export values already have tapered off. With the yen sinking further below exporters' breakeven point of 92.9, Q3 exports may show a more pronounced effect, with lower volumes, local currency revenues and values of repatriated Japanese assets. A strong yen also lowers import prices, counteracting efforts to end deflation.
Yet, the BoJ has been reluctant to make a direct intervention by selling yen and buying dollars. Increasing yen-denominated exports, falling breakeven rates for Japanese exporters and the rising incidence of overseas production have raised the bar for direct intervention in the currency market. However, none of these factors precludes further monetary easing by the BoJ as an indirect way to weaken the yen and, ultimately, to revive the economy. Should intervention materialize at all, it is unlikely to precede monetary easing.
If the yen continues to appreciate despite greater market liquidity after the summer, and the yen drags down the Nikkei, the BoJ will act to resist appreciation indirectly. The wealth effect from a stock market decline would be small (stocks represented only 17% of household financial assets at the peak of Japan’s stock bubble), and the impact on corporate financing would be minor, since Japanese firms raise capital through debt more than equity and are flush with retained earnings. Still, a sustained decline in share prices would strain cross-shareholding relationships between banks and non-bank firms. If the increased yen supply fails to curb appreciation, the BoJ will then intervene in the market.
RGE sees little chance of either monetary easing or intervention occurring before the end of August, when BoJ Governor Shirakawa returns to Japan from the Jackson Hole Symposium for central bankers. Though unlikely, it is far from impossible the BoJ will act earlier and intervene when we least expect it—the element of surprise enhances the effectiveness of intervention.
BoJ intervention is more likely after the DPJ leadership turnover on September 14, as all the contenders are campaigning on intentions to weaken the yen. The victor could use his election as a popular mandate for intervention. Should the BoJ assert its independence and refuse, Japan’s new prime minister would look into alternative measures to weaken the yen, such as the announcement of an additional fiscal stimulus measure. Note we say "announcement"—given the DPJ’s focus on fiscal rebalancing, an actual increase in public spending would run counter to its earlier promise to scale back the budget by 10% in FY2011. Therefore, the DPJ may announce an additional form of stimulus to scare off yen buyers but not actually increase spending. Rather, it could spend what is left of its stimulus funds from FY2010 and/or reallocate the budget to needier areas.
1) Monetary easing: At first, the BoJ will attempt to weaken the yen by easing monetary policy, as it did after the Dubai shock in December 2009. It may do so by increasing the size or lengthening the terms of loans provided at its funding facilities—such as the JPY3 trillion program to spur corporate lending to high-growth industries (such as green technology or health care) or the JPY20 trillion fixed-rate bank funding scheme that was introduced during the Dubai debt crisis. It could also enter quantitative easing and purchase JGBs or other assets outright. However, the government’s promise to cut public spending may obviate JGB purchases.
Expanding the BoJ's lending facilities may scare off yen investors, but it will not counteract the weak borrowing demand that has parried off such attacks on deflation. Many companies don't need more loans; they sit on piles of cash or park their retained earnings in government bonds or foreign securities. They see a lack of fixed investment opportunities at home and, amid worries over the faltering global recovery, overseas as well.
2) Intervention: The BoJ would use physical intervention as a last resort. Shirakawa resists meddling in the market as he believes monetary policy is not the answer to Japanese deflation and cannot provide significant stimulus anymore. The overnight call rate is already down to 0.1%, yet locals eschew borrowing. Besides, the effects of unilateral currency interventions tend not to last and, as the Swiss central bank's interventions earlier this year show, victory is Pyrrhic at best. Coordinated intervention to weaken the yen like the G7 did in 1995 is out of the question given other countries are also struggling to sustain export growth.
3) Fiscal policy: If the BoJ doesn't budge on the yen, the government might. Politicians obsess over fiscal policy and monetary policy as if they were the only ways out of Japan’s stagnation, overlooking regulatory barriers to Japanese growth. Therefore, the DPJ may announce an additional fiscal stimulus package or even renege on its promise to cut spending. In either case, the government would be silent on how it could still achieve fiscal rebalancing.
To boost consumption, at least temporarily, Japan's fiscal policy makers could step in and extend the deadline on subsidies for eco-friendly cars. Vehicle sales waned before the end of the subsidy program because of customers' fears that popular models purchased in July or August would arrive too late to qualify. The end of similar subsidies in Europe caused auto sales to drop at double-digit rates on an annual basis. Toyota and Honda plan to cut output after the subsidy ends in September, which will slow production down the supply chain and threaten jobs and overtime pay.
The yen has fallen below the 85 per USD level that triggered the policy easing during the Dubai debt crisis in late 2009 and is far below the 109 level that triggered the BoJ’s last physical intervention (yen-selling, dollar-buying) back in 2004. Yet, there has been neither monetary easing nor direct intervention from the BoJ, only verbal interventions from the MoF. The anti-climactic emergency meeting between Shirakawa and Prime Minister Naoto Kan contained no discussion of intervention and was relegated to a mere 15-minute phone call. What is the BoJ waiting for—the yen to strengthen further to the record 79.75 per USD that triggered the 1995 joint intervention between the BoJ and the Federal Reserve?
Long story short: This time it’s different. Here are four reasons:
1) Exporter breakeven rates have trended lower since 1987. Whereas exporters needed a USD/JPY exchange rate of 140.9 for revenues to break even with production costs back in 1987, exporters now only need the yen to be as weak as 92.9 per USD (Figure 1), according to a 2009 survey by the Japanese Cabinet Office. When the BoJ intervened to weaken the yen in 2004, the USD/JPY spot rate was only about JPY3 lower than the breakeven rate. Ahead of the 1995 intervention, the spot rate was JPY24 lower than the breakeven rate. At 84 as of August 26, 2010, the USD/JPY rate is JPY9 lower than the 2009 breakeven rate. If the BoJ is waiting for the spot-breakeven spread to widen to its 1995 level, the yen still has a ways to go before the BoJ intervenes.
Figure 1: Exporter Breakeven Rates
Source: MoF, BoJ
2) Japanese exports are increasingly invoiced in yen, hence minimizing the valuation impact on foreign earnings translated back into yen. Therefore, the strengthening yen does not hurt the bottom line of exporters as much as it did back in 2000, when 52.4% of Japanese exports were denominated in U.S. dollars (Figure 2). The U.S. dollar still dominates at 48.6% of exports, but the yen’s share has climbed from 36.1% of exports in H2 2000 to 41% in H1 2010—the highest since MoF records began. Exports to Asia, a growing portion of Japanese exports, are about evenly split between the U.S. dollar and the yen. Asian currencies gradually have gained market share but still only denominated 2% of exports as of H1 2010.
Figure 2: Japanese Export Invoicing Currencies
Source: Japanese Cabinet Office, BoJ
3) Japanese manufacturers have been moving production offshore to cut labor and transportation costs (Figure 3). Since the products are already denominated in the currency of the consuming country—as in the case of Japanese automobiles made and sold in the U.S.—a strengthening yen does not cut into their price competitiveness. The exchange rate can still impact earnings, though, when companies repatriate them back to Japan. However, some of these foreign earnings can be plowed back into overseas investments. Currency appreciation encourages overseas investment, as a stronger yen can buy more foreign land, machinery, equipment and labor.
Figure 3: Overseas Manufacturing
Source: Japanese Cabinet Office
4) Effective exchange rates—the trade-weighted exchange rate of the yen versus a basket of currencies—are weaker than the USD/JPY suggests. While the yen has strengthened versus the U.S. dollar, euro and other major currencies on a bilateral basis, its trade-weighted indexes have actually weakened so far this year. The index of the yen’s nominal effective exchange rate, or NEER, averaged 118.8 as of July 2010, far weaker than the historical average of 78.5. The index of the yen’s inflation-adjusted or real effective exchange rate, REER, also weakened this year to 103.4, which is just about average for the REER historically. Both the NEER and REER now are much weaker against the exporter breakeven rate than they were when the BoJ last intervened in 2004. The chart below illustrates this, with dotted vertical lines marking intervention episodes when the BoJ sold yen.
Figure 4: Japanese Yen: NEER and REER
Source: BoJ, RGE
One of the factors behind the discrepancy between the major bilateral exchange rates and Japan’s trade-weighted exchange rates is the changing composition of Japan’s export market. Asia’s share of Japan’s total exports has grown from 29% in 1979 to 54% in 2009, while North America’s share shrank to 17% and the EU’s stayed steady at 12%. As Asia’s share has grown, so has its weight in the basket of currencies against which the yen is valued.
Figure 5: Japanese Export Destinations
Source: MoF, RGE
The NEER has weakened more than the REER since 2005 due to rising production costs in Japan’s trade partners. Japan’s domestic corporate goods price index has been relatively flat compared to, say, the U.S. producer price index. Due to higher inflation in its trade partners, Japan’s exports are overall more competitive than the goods produced locally in the receiving countries.
Figure 6: Production Costs: Japan vs. U.S.
Source: U.S. Bureau of Labor Statistics, BoJ
In short, the increasing yen denomination of exports, falling breakeven rates for Japanese exporters, overseas production's larger share of the total and still-modest effective exchange rates all raise the bar for direct intervention in the currency market. None of these factors precludes further monetary easing by the BoJ as an indirect way to weaken the yen and combat deflation, but the BoJ will require more than pleas from the government before resorting to direct intervention.
What Else Could Be Holding Back the BoJ?
1) An overwhelming sense of the futility of intervention in the face of deflation and stagnation: The real interest rate gap between the U.S. and Japan has turned in the yen’s favor. As long as Japan’s real interest rates remain positive due to deflation and the U.S. real interest rates remain negative due to inflation, the yen looks like the higher-yielding currency. Though Japanese deflation is slowing and U.S. inflation may turn into deflation, the rate gap is unlikely to reverse until 2011 at the earliest. Moreover, the Federal Reserve’s relatively aggressive monetary policy easing compared to that of the BoJ will continue to turn investors toward the yen.
2) JGB purchases: The government issued less short-term debt than is maturing, forcing banks to buy longer-term JGBs. This, in conjunction with expectations for the BoJ to maintain low interest rates for years, will increase demand for JGBs across the yield curve. Increasing JGB demand will boost demand for yen, eroding the effects of any intervention.