IHS Global Insight Perspective
The Bank of Japan (BOJ) on Tuesday this week engaged in its first major foreign-exchange intervention since 2004, an indication of concern regarding the country's growth prospects.
By lowering the value of the yen, even temporarily, the BOJ hopes to spur exports and prevent a double-dip recession.
The yen could be weakened by the intervention, especially if it is continued in coming months; however, much of this competitiveness gain could be offset by a higher inflation (or lower deflation) rate.
The Bank of Japan (BOJ) engaged in foreign-exchange intervention for the first time in six years on Tuesday this week. It sold yen and bought dollars in currency markets in order to weaken the value of the yen and thus keep exports competitive and promote economic growth. The BOJ has been following this "mercantilist" approach for decades—promoting exports and income, even as it makes the cost of living more expensive by raising the price of imported goods. This latest intervention was moderate: market participants estimated the intervention at ¥1 trillion (US$11.7 billion). In comparison, previous interventions in 2003 and 2004 were roughly ¥20 trillion each. Of course, the BOJ can repeat the intervention many more times if it so desires, so the 2010 total could rival the large numbers of 2003 and 2004.
Does It Work?
The immediate effect of the intervention was a slight weakening of the yen. This is not surprising: not only did the BOJ increase the supply of yen in the foreign-exchange market, but it also increased the stock of yen currency relative to dollars, euro, and other currencies—similar short-term effects have been seen in previous interventions. But the long-term effects are more controversial. Six years ago, the BOJ sold trillions of yen; over the next two years the yen depreciated approximately 10%, which would seem to imply that the intervention was effective. But this could have been a normal correction to the unusually strong value of the yen—the subsequent weakening could have happened even if there was no intervention. Moreover, the intervention would have increased the money supply and thus raised inflation (or decreased deflation)—if so then the yen depreciation would have been offset by higher yen prices, thus eliminating any competitive advantage.
Maintaining External Surpluses
The rationale behind the intervention is that a weaker yen will promote exports and thus economic growth. This may be true while the intervention is in progress, but after that the private sector must respond. Higher exports increase the trade- and current-account balances, which increases yen-buying. To offset this there must be increased capital outflows from Japan to the rest of the world, otherwise the yen would immediately rebound. In fact, the private sector appears to have done just that: in the mid-2000s, after the massive BOJ intervention, capital outflows rose to counterbalance the increased current account. This could have been a coincidence, with Japanese investors' preferences shifting to overseas assets right after the BOJ's intervention. Or perhaps the BOJ shifted the economy to a different equilibrium path, one with larger current-account surpluses, although this would conflict with traditional monetarist theory.
Outlook and Implications
The Real YenWith all the discussion of the (nominal) exchange rate, it is easy to lose focus on the real exchange rate. The yen has been strengthening for decades, but during that time Japan has had considerable deflation. In fact, the deflation has often outstripped yen appreciation, making Japan "cheaper" in dollar terms than it was in previous years. This real exchange rate shows that Japan's international price level—its competitiveness—is still at the same level as it was in 2005, even after the recent nominal appreciation. This is not a surprise; the real yen has been trending downward for years, accompanied by rising trade surpluses and capital outflows. It seems likely that this trend will change soon, with yen appreciations that outweigh deflation and thus raise Japan's price level on world markets. But this will only happen if capital outflows—referring to Japan's preference for foreign investments—remain steady. If capital outflows continue to trend upwards—which is possible, considering the low return on domestic investments—then the real yen could continue to weaken. This would be reflected in a steady nominal exchange rate, perhaps in the low ¥80/US$ range, while deflation continues to lower Japanese prices.