Japan’s foreign exchange market intervention earlier this month rekindled longstanding debates over whether intervention ‘works’. But whether it works is an incorrect or at least too simple framing. There is no easy answer.
The assessment depends on numerous factors, including what one is trying to achieve. Often, analysts assessing this question are considering whether intervention can substantially move an exchange rate away from a baseline for an extended period.
That said, I am sceptical as to whether Japan’s most recent intervention is working.
Disorder versus misalignments
Foreign exchange markets can become volatile and disorderly, constraining the ability to get business done – short or long speculative positions can be feverishly built up. A currency can also be substantially ‘misaligned’, but that often reflects an imbalanced policy mix. For example, the dollar surged in the early 1980s on the back of an extremely tight monetary and expansionary fiscal policy that sent US real interest rates soaring and attracted huge inflows.
Intervention is far better able to burn speculative positions when markets are disorderly, but it is less adept at coping with misalignments that are better tackled through changes in fundamental policies.
According to most models, the yen is quite undervalued and the dollar overvalued, largely reflecting wide US-Japanese interest differentials and relative monetary policy stances. Those diverging stances seem entrenched for the period ahead.
The Japanese intervention may have caught substantial short yen positions off guard, resulting in rapid short-covering and a boost to the yen. But the current yen-dollar exchange rate primarily reflects diverging fundamentals.
Change versus no change in accompanying fundamentals
Intervention is most likely to have a durable impact when accompanied by or foreshadowing changes in underlying policies. One way the intervention literature addresses this point is through the debate over sterilised versus unsterilised intervention.
In the unsterilised case, the prospects for intervention bringing about exchange rate change are far better. For example, if foreign central bank dollar purchases result in a corresponding expansion in domestic liquidity, the stance of monetary policy will ease and the exchange rate is more likely to depreciate. But if the central bank sops up the expansion in domestic liquidity (sterilised), the overall stance of monetary policy will remain unchanged and the foreign exchange impact will be far less certain. In effect, Japanese foreign exchange intervention is for all intents and purposes sterilised.
Major versus minor currencies
Foreign exchange markets trading is quite different for highly liquid major currency pairs backed by large, deep and open capital markets than it is for small sequestered markets with capital controls and limited convertibility. The impact of intervention in the former case is unclear, especially if domestic and foreign assets are substitutable. In the latter case, authorities are far better placed to exert control through intervention and other restrictions. Dollar-yen trading is far more reflective of the former than the latter scenario.
Going alone versus coordinated intervention
Intervention in the major currencies rarely takes place. There were concerted G7 operations in the euro in 2000 and the yen in 2011. On both occasions, the G7 issued a statement and US, Japanese and European authorities all intervened. Japan has intervened alone, though, in 2022 and just recently. Concerted joint operations send a more powerful signal to foreign exchange markets.
Long term versus one-off
Intervention is more likely to be impactful if it is large scale and carried on in a sustained campaign versus a one-off operation. But even that assertion merits qualification.
Japan undertook massive, protracted operations to slow yen appreciation and guard against deflationary pressures in 2003-04, amounting to 7% of GDP. Analysts believe that the intervention might have been more effective earlier on as it coincided with an expansion in Japan’s monetary base, whereas in the later stages it was seen as more predictable and wasn’t accompanied by an increasing monetary base.
The Chinese foreign exchange market is subject to far great control from authorities. Yet, China spent $1tn defending the renminbi in 2015-16, but still faced continuous waves of downward pressures. Of course, the counterfactual of what would have happened without intervention cannot be assessed.
Policy-makers need to be seen as doing something. In the late 1970s, the dollar was being continuously pummelled. The market lacked trust in US macroeconomic policies and authorities. The US intervened almost daily, seemingly to little effect. A Treasury boss reflecting on the experience once told me that the US wasn’t in a position to change fiscal or monetary policy, but that senior officials had to be seen as trying to ‘do something’. Thus, the US intervened. A similar ‘do something’ dynamic may now be at play in Japan.
Will Japanese intervention work?
A durable yen appreciation will most likely require a narrowing in US-Japanese rate differentials, either from a cooling in the US economy and inflation or reduced accommodation from the Bank of Japan, or both. On balance, Japan’s recent interventions may have burned some short positions and provided the yen a brief fillip. While the yen jumped some 4% against the dollar, it is already easing back. Market conditions seem calmer, but participants have already renewed discussions about whether the Japanese authorities will again re-enter the market.
Some analysts may wish to call that short-term fillip a ‘success’. Others will be sceptical over whether much has been achieved. I’m more in the latter camp.
Regardless, economists will continue debating whether intervention ‘works’ for many years to come, even if the proper answer is that ‘it depends’.
Mark Sobel is US Chair of OMFIF.
