Intervention in currency markets can work

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The writer is a senior fellow at the Council on Foreign Relations

Not long ago, there was almost a consensus that Japan’s intervention in the foreign exchange market would not work because the country’s interest rate differential against the US – which had propelled the yen to record lows – was simply too wide.

This consensus reflects somewhat outdated research showing that, without capital controls, intervention works only when coordinated and supported by broader monetary and fiscal policy changes. This conventional wisdom is incorporated into the IMF’s core model for evaluating intervention impact. This model assumes that intervention is completely ineffective for large, open and advanced economies.

However, Japan’s intervention underpinned the yen this summer. So did the country’s intervention in October 2022. Theories about the general ineffectiveness of the intervention need to be updated.

There are three reasons why intervention may be more effective than conventional financial wisdom suggests. First, in the case of Japan, the government is a major player in the market. Most analysts look at intervention relative to market turnover, but this daily loss is often largely a function of market participants trading among themselves in response to more modest actual flows.

Japan’s government has a lot of foreign assets – the Ministry of Finance has $1.2 billion in reserves, and the Government Pension Investment Fund has about $800 billion more. These assets are not hedged and account for more than half of Japan’s total net external asset position. The Japanese government is therefore the biggest financial beneficiary of the yen’s weakness.

Think of it this way: If the winner of a big financial bet never makes a profit, that impacts the market – because the government’s earnings are large relative to the $50 billion – $100 billion in foreign purchases that often come from from Japanese “private” investors. There is another corollary: when Japan’s Ministry of Finance sells dollars bought at 80 yen or 100 yen to the dollar for 150 yen or 160 yen, it makes a considerable profit. This profit goes somewhat against the standard market view that intervention “wastes” scarce foreign exchange.

Second, many studies of intervention ineffectiveness focus on the wrong variable. Intervention tends to work not by sustainably strengthening a currency, but by credibly establishing a below-market level. For example, if the government is expected to intervene at 162 yen against the dollar, and if the Japanese currency is currently trading at 160 yen, the distribution of probability returns is skewed: bad news for the yen will not cause the yen to depreciate significantly, but news good for the yen could lead to a big appreciation.

Intervention to put a cap on an appreciating currency works the same way – the market knows the currency won’t be allowed to get much stronger, but nothing stands in the way of depreciation. That is why so many Asian countries were able to successfully engage in “competitive aversion” in the decade of foreign currency manipulation from 2003 to 2014.

Third, in the case of Japan, the government’s actions may send a signal to a much wider group of regulated institutions that must decide whether to partially or fully hedge their foreign bond holdings. The quasi-public institutions—Japan Post Bank, Norinchukin Bank, and the investment fund for small savings banks (Shinkin Central Bank)—collectively hold nearly a trillion dollars of foreign bonds. The extent to which these bonds are hedged has an impact on the markets. The same is true of the big nine life insurers, which went from holding about $360 billion of covered bonds and $240 billion of uncovered bonds in the fiscal year to March 31, 2020 to about 185 billion covered and $215 billion uncovered at the end of 2023. fiscal year. While the government stayed out of the market, these institutions let their coverage rates drop to lower costs and increase profits.

None of these arguments negate the reality that interest rate differentials matter for countries with open financial accounts. High US short-term rates make hedging expensive. High long-term US rates make unbacked dollar bond holdings attractive. But Japan’s government is potentially a big player, not a small one – and intervention can still shape the short-term distribution of risk and return.

Uncoordinated currency intervention is more difficult for large, open and advanced economies, especially those that lack the enormous firepower of the Japanese government. But after recent experience, it is a mistake to assume that it can never work.