Europe’s Stake in the US Treasury’s Yen Gamble
Washington’s decision to bypass G7 co-ordination and sell euros to support Japan’s currency raises questions about European sovereignty, even as the euro’s resilience confirms its growing global role. A commentary by Lorenzo Bini Smaghi
The extraordinary intervention in the foreign exchange market carried out by the US Treasury on Friday 31 July to support the Japanese yen has raised serious questions, both about the way it was conducted and about its underlying rationale.
The first concern is the absence of any reference to the G7 coordination framework, which in the past provided the basis for all interventions in foreign exchange markets. This is the first time that a purely bilateral operation has been undertaken by the finance ministries of the two countries. The last intervention involving the yen, in 1998, was conducted within the G7 framework.
This is a significant departure. Foreign exchange interventions affect not only the relationship between the currencies directly involved, in this case the dollar and the yen, but other currencies as well, starting with the euro. On this occasion, the US and Japanese authorities acted without regard for the others, ignoring the system of monetary cooperation developed over the past 40 years.
Media reports suggest that the European Central Bank was “notified” of the intervention. By contrast, European finance ministers, and in particular Eurogroup President Kyriakos Pierrakakis of Greece, appear to have been kept in the dark. Yet in Europe, exchange rate policy is a shared responsibility of the central bank and the political authorities.
This is all the more surprising because the purchase of the Japanese currency was conducted not against dollars, but against euros. The European authorities were not asked for permission.
The second concern relates to the objectives of the foreign exchange operation. The explanations provided publicly are not particularly convincing.
The official justification was that the yen’s exchange rate had become excessively volatile and that the currency was at risk of collapsing. The data, however, show that the volatility of the Japanese currency was no greater than that of other currencies.
As for the yen’s depreciation over recent months, it largely reflects the gap between short-term interest rates in the United States, at just under 4 per cent, and those in Japan, which remain at 1 per cent. Under these conditions, borrowing in yen and investing in dollars represents a particularly profitable speculative strategy, the so-called carry trade.
The yen’s depreciation is, in fact, primarily the result of the different underlying conditions of the two economies. As long as this divergence persists, the yen will continue to depreciate and interventions in the foreign exchange market will have only temporary effects.
To counter the yen’s depreciation, the interest rate differential would have to narrow. The Federal Reserve would need to cut US interest rates, while the Bank of Japan would have to raise Japanese rates. In the current environment, however, neither move appears particularly plausible.
As long as inflation remains high in the United States, the Federal Reserve is more likely to raise rates than to cut them. In Japan, rates should rise, but the central bank is facing pressure from the government to move in the opposite direction.
The market appears to have understood this. The joint intervention initially strengthened the yen by around 8 per cent, but after a few days the Japanese currency gradually began to slide again.
Some commentators suspect that the intervention’s real purpose is to put pressure on the Federal Reserve and discourage it from raising interest rates at its next meeting in September. If the Fed will raise rates, the effects of the recent intervention will vanish and the pressure on Japanese government bonds will rise again.
Yields on ten-year Japanese government bonds recently reached 2.75 per cent, a level not seen for 30 years. Yields on 30-year bonds climbed as high as 3.90 per cent.
The US Treasury fears that a crisis in Japan’s public debt, which has stabilised at around 205 per cent of GDP, could spill over into the US Treasury market.
The intervention was conducted in euros rather than dollars precisely to avoid encouraging the sale of US government bonds, which would have had a negative impact on investor confidence.
The most interesting aspect, and one that has attracted little attention from commentators, concerns the intervention’s effects on the euro-dollar exchange rate. One might have expected the sale of euros to weaken the European currency. Instead, the euro held its ground and even appreciated against the dollar.
This suggests that financial markets now regard the euro as sufficiently robust and liquid to absorb this kind of intervention. It also indicates that investors are not entirely convinced by the merits of the US Treasury’s action nor by its consistency with monetary policy.
The US intervention to support the yen is not yet an own goal, but it may soon become one.
A previous version of this article was published in the Italian daily Il Foglio
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
