FRBSF Economic Letter
2003-36; December 12, 2003
Japanese Foreign Exchange Intervention
Pacific Basin Notes. This
series appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific Basin Monetary
and Economic Studies within the FRBSF's Economic Research Department.
In 2003, the Bank of Japan (BOJ) intervened vigorously on behalf of the
Ministry of Finance (MOF) in foreign exchange markets in efforts to reduce
the value of the yen. This action was motivated by the perception that
an excessively rapid rise in the value of the yen would hinder the fledgling
economic recovery by reducing the competitiveness of Japanese exports.
Total foreign exchange intervention over the first ten months of 2003
amounted to over 17 trillion yen in assets, almost double the previous
record for that length of time.
Several media reports claimed that these intervention efforts by MOF
were initially successful. Some private analysts estimated that in the
absence of intervention activity, the yen could have risen about 10%
higher over the second quarter than it did.
This success, even over a period as short as a quarter, appears to
pose a puzzle, because it runs counter to most economists' expectations.
The
evidence in the literature suggests that foreign exchange intervention
is unlikely to have any lasting impact on exchange rates in economies
with free capital mobility, such as Japan. This would be particularly
true for Japan, where the prevailing close-to-zero nominal short-term
interest rates create ambiguity about the impact of foreign exchange
intervention on the money supply.
In this Economic Letter, I examine
the conditions under which economic theory would predict that foreign
exchange interventions under near-zero
short-term interest rates are likely to be successful. I then discuss
the difficulties in assessing the success or failure of a foreign exchange
intervention. Finally, I focus on Japan's recent experience. I argue
that while there are always difficulties in assessing the success or
failure of a foreign exchange intervention, the Japanese case does appear
to provide evidence that foreign exchange interventions in the neighborhood
of zero interest rates can have persistent, albeit temporary, impacts
on the exchange rate.
Was Japan's foreign exchange intervention
sterilized, and does it matter?
In theory, sterilized foreign exchange interventions
tend to be less effective at moving exchange rates than unsterilized
interventions. Sterilized
intervention requires the central bank to follow the intervention, such
as buying dollar assets with yen-denominated currency, with a countervailing
sale of yen assets to mop up the extra yen that that would otherwise
be injected into the economy. Thus, the intervention would have no impact
on the domestic money supply and would only alter the public's relative
supplies of available yen and dollar assets. In the past, Japanese foreign
exchange intervention was almost universally sterilized (Ito 2002). Currently,
the intervention would also be formally considered sterilized as the
dollar purchases are financed by the sale of yen assets issued by the
MOF.
Nevertheless, the media have characterized the recent interventions
as "unsterilized" because
the Japanese money supply has steadily increased along with the intensive
intervention activity. The Nikkei Financial Daily recently noted that
the total value of interventions from the beginning of the year until
the end of August matched almost exactly the increase in the BOJ's current
account balance over that period, suggesting that the BOJ left the funds
associated with its intervention activity in the market.
However, there
appears to be little correlation between these variables at higher frequencies,
such as day-to-day data. This sheds doubt on a
one-to-one correspondence between intervention activity and movements
in the BOJ current account balance. Instead, it appears that the BOJ
incorporates the foreign exchange intervention it conducts on behalf
of the MOF into its overall portfolio of daily money market transactions.
The pursuit of foreign exchange intervention on behalf of the MOF therefore
does not preclude the BOJ from achieving its domestic money supply targets,
as the BOJ can maintain these targets by adjusting its other transactions
accordingly.
More importantly, it is unclear that sterilization under
near-zero nominal rates matters. Traditionally, unsterilized intervention
is considered
likely to be more effective because it also expands the domestic money
supply. However, in Japan today, short-term securities appear to be nearly
perfect substitutes for currency, so the expansion of the money supply
need not have any additional impact on the economy. In short, under near-zero
short-term interest rates, an unsterilized intervention may be little
different from a sterilized intervention (see, for example, Okina and
Shiratsuka 2000).
Real effects of sterilized intervention
Since the expansion of the money
supply in unsterilized interventions is unlikely to have direct real
effects under near-zero nominal short-term
rates, one must turn to the literature on the effects of sterilized intervention
to understand how the intervention may have resulted in a lower value
of the yen. In their recent survey, Sarno and Taylor (2001) discuss two
channels for sterilized foreign exchange intervention to have real effects:
(a) a portfolio balance channel and (b) an expectations channel. The
portfolio balance channel assumes the public considers foreign assets
to be imperfect substitutes for domestic assets; in Japan's case, the
public would consider assets denominated in yen and assets denominated
in dollars to be imperfect substitutes. Following an intervention against
the yen, the public would find itself holding a larger share of yen assets
than before. At prevailing exchange rates, this would induce people to
attempt to sell these extra yen assets to rebalance their portfolios.
As a result, the exchange rate value of the yen would fall below what
its value would have been without the intervention.
Under the expectations
channel, foreign exchange intervention conveys a signal that changes
the public's expectations about the future exchange
rate path. In the case of a successful intervention against the yen under
the expectations channel, the change in public expectations may reflect
either a change in expectations concerning future Japanese monetary policy
or a change in Japanese economic fundamentals. The expectations channel
also may provide an opportunity for sterilization to matter under zero
nominal rates. Sterilization can have real effects if public expectations
about future monetary policy depend on whether interventions were sterilized.
For example, if leaving the interventions unsterilized left the public
more convinced about the BOJ's determination to stimulate the economy,
then sterilization, or the lack thereof, may indeed matter.
However, the
potential effectiveness of either of these channels is unclear. Since
both the United States and Japan maintain unrestricted capital
markets, their short-term securities are likely to be highly substitutable.
The expectations channel seems more promising, as the intervention activity
may have reinforced expectations of a more expansionary monetary policy
stance by the BOJ under its new Governor, Mr. Fukui.
Measuring foreign
exchange intervention success
It can be very difficult to assess the success
or failure of foreign exchange intervention for several reasons. First,
the MOF claims that
they intervene only when exchange rate levels deviate from true underlying "fundamentals." This
implies that when the MOF intervenes against the yen, fundamental forces
may be at play that would tend to move the value of the yen on their
own. Thus, it is difficult to distinguish whether yen movements reflect
interventions or changes in fundamentals that led to them.
Second, it
is very difficult to assess the timing of the market's response to a
foreign exchange intervention, because it is difficult to determine
the extent to which the market anticipated it. If the foreign exchange
intervention were anticipated, then speculators would be likely to respond
to its anticipated impact before it actually occurred. Alternatively,
if the market were initially somewhat uncertain about the magnitude of
an intervention, its response might be delayed until the true magnitude
was revealed.
Finally, it is often difficult to tell whether exchange
rates move because of an intervention or because the fundamentals changed.
For example,
the strengthening of the yen in August 2003 may be due to the cessation
of intervention activity that month; or, it may be due to the relatively
good economic news that emerged from Japan that month.
Despite these complications,
the very large activity in the second quarter of 2003 still offers a
promising opportunity to find evidence of successful
foreign exchange intervention. The channels above that suggest how intervention
can have real effects would tend to be stronger the larger is the magnitude
of the intervention.
Perhaps more importantly, the performance of the
yen relative to the euro over this period gives us a good benchmark for
measuring the success
or failure of the Japanese intervention. Over the second quarter, the
news about real economic activity coming out of Europe was negative,
while for Japan, the news about economic prospects was relatively positive.
For example, the Economist poll increased its forecast for 2003 real
GDP growth for Japan from 0.2% to 0.9% between its March 1 and June 7
issues. Over the same period, its forecast for 2003 growth in the euro
area decreased from 1.3% to 0.8%.
Holding all else equal, this combination
of news would likely lead to an appreciation of the yen relative to the
dollar.  However, this did
not happen in the first half of 2003 (see Figure 1). Over the course
of the second quarter the yen actually depreciated 8.9% against the euro,
while the yen was kept within a narrow trading band relative to the U.S.
dollar. For the first half of the year, then, the data suggest that the
intervention activity had some success in keeping down the value of the
yen.
However, this "success" of the intervention does not necessarily
imply that it increased Japanese welfare. Over the four months ending
in October 2003, the yen appreciated 7.8% against the dollar and 7.6%
against the euro, reversing much of the yen-euro depreciation that had
been achieved in the second quarter—despite even greater intervention
activity than in the second quarter. Moreover, the intervention activity
this year has clearly resulted in significant capital losses for the
central bank in light of the yen's ultimate appreciation, although these
losses have been mitigated by the favorable movements in yen interest
rates.
Conclusion
Exchange rate movements over the second quarter of 2003 do
suggest that the extensive foreign exchange intervention has had at
least temporary
effects. For the first eight months of the year, there has been unprecedented
stability in the yen-dollar: its rate remained between 115 and 122
yen to the dollar. This is the narrowest trading band these currencies
have
exhibited since the breakdown in the Bretton Woods system, indicating
that the rates moved in the direction intended by the intervention
activity. Moreover, the yen-euro rate moved in exactly the opposite
direction that
would be expected given the news emerging from those areas during
this period. The empirical evidence, therefore, appears to support the
contention
that foreign exchange intervention achieved some success in the early
portion of the year, despite the near-zero nominal interest rates.
Even
in this case, however, the effects appear to be temporary. The depreciation
of the yen relative to the euro that was achieved through
the extensive
foreign exchange intervention efforts in the early half of the
year was completely offset by the end of August. Moreover, the yen appreciated
dramatically against the dollar after the cessation of intervention
activity
around the time of the September G-7 meeting in Dubai; however,
the
resumption of intervention appears to have slowed this appreciation.
Mark
M. Spiegel
Senior Research Advisor
References
Ito, Takatoshi. 2002. "Is Foreign Exchange Intervention Effective?
The Japanese Experiences in the 1990s." NBER Working Paper 8914
(April).
Okina, Kunio, and Shigenori Shiratsuka. 2000. "The
Illusion of Unsterilized Intervention." Shukan Toyo Keizai (January
15).
Sarno, Lucio, and Mark P. Taylor. 2001. "Official Intervention
in the Foreign Exchange Market: Is It Effective and, If So, How Does
It
Work?" Journal of Economic Literature 39(3), pp. 839-868.
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