The dollar and yen: why they matter

published 4 November 2005

Why is Japan intervening? Because it believes the yen needs to be held down to keep Japanese exports competitive. Thanks to a decade of deflation, Japan has suffered from anaemic consumer spending as households stave off spending in the expectation of lower prices in the future. As a result, Japan must look to its export sector to revive growth. A policy of intervention puts yen in the hands of foreigners, who are more likely to spend them than the Japanese themselves. At the same time, keeping the yen low helps the fight against deflation: it leads to higher import prices.

How much has Japan spent on currency intervention?

The policy of intervention began in earnest in August last year, when the decline of the dollar gathered pace. In 2003, the Japanese government spent $100bn buying dollars in an attempt to hold down the value of the yen. In the first two months of this year, it spent another $100bn. And Japan's parliament has authorised the spending of a further $360bn this year.

How does this policy of intervention work?

The Japanese government has been paying for its dollar-buying spree by issuing Financial Bills (FBs). These are short-term debt instruments that mature in three months. The attraction of this form of financing is that it is cheap: the FB interest rate for the 25 February bidding was 0.0055%. In theory, anybody can buy the FBs, but most of them are bought by the Bank of Japan. The government then uses the proceeds of the sale of FBs to buy dollars, typically in the form of US Treasury bonds.

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How successful has this been?

The Japanese government has not specified a target for the dollar-yen exchange rate, but the aim is probably to keep the dollar above 110. Without intervention, many believe the dollar would have slid below 100 last year. In early February, it fell back to 105, but after repeated intervention climbed back to 112. Recently, it has slid back to 106 after the Japanese failed to intervene last week, prompting suggestions that the policy may be abandoned. The architect of the policy, and hence one of the most powerful men in the world, Zembei Mizoguchi, vice-minister for international affairs at Japan's Ministry of Finance (known in the markets as "Mr. Dollar"), says he will continue to intervene to prevent sharp fluctuations in the exchange rate, but many believe the government can live with the yen at 105.

What happens to the dollars?

Japan has accumulated the largest foreign currency reserves in the world, amounting to some $777bn, of which more than $500bn is in US Treasury bonds. Some of these dollars have been acquired directly as a result of the currency intervention; others have been acquired indirectly, as a result of Japan's huge trade surplus with the US, itself a reflection of Japan's competitive currency. Japanese investors bought half of all US Treasury bonds last year.

What's the impact on the economy?

The intervention itself has a neutral impact, since the Ministry of Finance issues a dollar's worth of yen-denominated bonds for every dollar it buys. This means its intervention policies are 100% "sterilised". Indeed, if the dollar plunged against the yen, it could even be harmful for the Japanese economy, since the MoF would be left holding large quantities of devalued Treasury bonds, but would have yen liabilities.

Why do people talk of Japan printing money?

This is scare-mongering. Japan's intervention activities make no difference to the overall supply of yen in the world, since the intervention is fully sterilised. The policy of intervention is quite distinct from the ongoing policy to reflate the Japanese government by flooding it with cheap credit, which began long before the dollar started to fall. The only way the intervention policy could lead to asset bubbles elsewhere in Asia is via the accumulation of large trade surpluses as a result of the boom in exports. Intervention has kept the dollar high and US interest rates low, which has allowed the US to continue to import vast quantities of goods from Asia. This has undoubtedly led to boom conditions in some countries, notably China. In the 1990s, a similar set of conditions led to over-heating, but there is little sign of that today, except possibly in China itself.

Is the policy of intervention unsustainable?

Probably. The main problem in the short-term would be a rise in Japanese interest rates. This would cause the yen to rise, which would then have to counteracted with further intervention, while at the same time raising the cost of intervention as a result of the rising cost of issuing FBs. But it is unlikely Japanese rates will rise anything like enough to create a real problem. A bigger issue in the longer term is the growing quantity of outstanding government debt. The government can hardly redeem these debts by selling US Treasuries, since this would drive down the dollar and most likely drive up US interest rates, which suits no one. The result is that the Japanese government has to keep rolling over its debt, or selling longer-dated bonds. This could become very expensive.