The United States and Japan recently took coordinated action in the foreign exchange market, purchasing yen in an effort to support the Japanese currency after it fell to its weakest level against the U.S. dollar in roughly four decades. The unusual move highlights the importance of exchange rates not only for financial markets, but also for the wider economy.
The coordinated intervention came after the yen had weakened sharply against the dollar. Japan and the United States have indicated that they are prepared to take further action if necessary. (Reuters)
But why would governments intervene in currency markets in the first place? And what are they trying to achieve?
Why do countries intervene in currency markets?
Foreign exchange interventions generally pursue two broad objectives: protecting economic competitiveness and maintaining confidence in a country's currency.
When a currency moves sharply in a short period of time, the consequences can extend well beyond financial markets.
A currency that becomes excessively weak can make imported goods and raw materials more expensive. For countries that rely heavily on imports, this can increase costs for businesses and households and contribute to inflation.
Japan has been particularly concerned about the yen's weakness because higher import costs can put additional pressure on the economy. (Reuters)
How does a currency intervention work?
In a typical intervention designed to support a currency, authorities buy their own currency and sell another currency, often using foreign-exchange reserves.
In the recent U.S.-Japan operation, the authorities purchased yen to counter the currency's decline.
The immediate objective is to increase demand for the yen and discourage further selling. Such an intervention can also send a powerful message to financial markets: policymakers are prepared to act if currency movements become excessive.
Why was the United States involved?
The U.S. participation was particularly notable because currency interventions are relatively uncommon and coordinated action between Washington and Tokyo is unusual.
The intervention followed a sharp decline in the yen, which had reached levels around 160 yen per dollar and beyond, prompting concerns about excessive weakness. The two governments subsequently confirmed their coordinated action and indicated that they could intervene again if necessary. (Reuters)
For Washington, the issue is not simply the value of the yen. A disorderly move in one of the world's major currencies can have broader implications for global financial markets and economic stability.
A weak yen has advantages — but also disadvantages
A weaker currency is not necessarily bad for an economy.
Japanese exporters can benefit because their products become relatively cheaper for overseas customers. Companies generating significant revenues abroad can also see the value of those earnings increase when converted into yen.
However, there is another side to the equation.
Japan imports large quantities of energy, food and raw materials. A weaker yen makes those imports more expensive, potentially increasing costs for households and businesses.
This is one reason Japanese officials have become increasingly concerned about excessive yen depreciation.
Can intervention permanently strengthen the yen?
This is where the limitations of currency intervention become clear.
An intervention can produce a rapid market reaction and temporarily slow a currency's decline. It can also force speculative investors to reconsider positions that were based on expectations of continued weakness.
However, intervention alone cannot necessarily change the economic fundamentals driving a currency.
Recent market developments illustrate this difficulty. The yen initially strengthened significantly following the coordinated intervention but subsequently gave back part of those gains. Analysts have pointed to factors including the interest-rate gap between Japan and the United States and Japan's broader economic and fiscal conditions. (Reuters)
Interest rates remain crucial
One of the most important factors influencing the yen is the difference between U.S. and Japanese interest rates.
When investors can obtain significantly higher returns on dollar-denominated assets than on yen-denominated assets, there can be an incentive to move money toward the dollar.
That can increase demand for dollars while putting downward pressure on the yen.
This explains why a lasting recovery in the Japanese currency may require more than intervention in the foreign exchange market. Expectations surrounding Bank of Japan monetary policy and future interest-rate increases could also play a major role. (Financial Times)
More than just a currency-market operation
The U.S.-Japan intervention demonstrates how closely exchange rates are connected to the broader economy.
A sharp currency decline can influence inflation, consumer purchasing power, corporate profits, import costs, interest rates and financial-market stability.
That is why governments and central banks sometimes intervene when they believe exchange-rate movements have become excessive or potentially disruptive.
The recent intervention may help stabilize the yen in the short term, but its longer-term success will depend largely on economic fundamentals and monetary policy.
In other words, buying yen can slow a currency's decline, but restoring lasting strength usually requires investors to believe that the underlying economic conditions justify a stronger currency.
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