Bank of Japan and Intervention

During the second half of last year, with the yen trading at a record high of 76 yen to the dollar, the Bank of Japan was forced to act to protect the nation's vital export industry. The more the yen appreciates against the currencies of its main export markets, the less competitive Japan's products become and managing the yen exchange rate remains one of the greatest challenges for Japan's government and central bank officials.

Making up roughly 20 percent of Japan's total annual Gross Domestic Product, the importance of Japan's export sector cannot be overstated. However, the sharp increase in the yen during the final two quarters of last year was particularly ill-timed as it threatened to derail the recovery following the devastating earthquake and tsunami earlier in the year.

Japan Export Facts*
Total Exports – $770 billion
Top Three Export Markets
1. China – $150 billion
2. U.S. – $120 billion
3. South Korea – $62 billion

* 2010 statistics
All amounts in U.S. dollars

The Bank Steps In

To stem the yen's rise, the Bank of Japan engaged in another round of quantitative easing where the Bank purchased government securities. This would make trillions of yen in “new” cash available to the banking system where it was hoped the increased supply would exceed demand and ultimately devalue the yen.

The yen did slow its ascent immediately following each major purchase, but the relief was short-lived and by late January, the yen had climbed back to just over 76 yen to the dollar.
Since then, however, the situation has reversed and over the past six weeks, the yen has fallen and is currently trading at about 82 yen. This has certainly eased some of the pressure on the Bank to engage in further quantitative easing.

Nevertheless, officials continue to keep a close eye on the currency and despite the yen retracing from its highs last fall, the Bank introduced another round of bond buying last week. The latest action consisted of another 10 trillion yen (US$129 billion); all together, the Bank has invested 65 trillion (US$838 billion) yen in its current asset purchase program.

Given the decline in the yen, it may seem unnecessary for the Bank to continue its intervention at this time. However, the Bank of Japan has specifically identified the European credit crisis and the possible global implications of the debt crisis as the greatest economic threat to Japan for the remainder of the year.

The Eurozone countries and the U.K. have both seen growth expectations for the year reduced because of the Eurozone's sovereign debt concerns. In the U.S., the economy continues to improve at a slow rate, but unemployment remains “elevated” and consumer demand is still very weak. Even China, the so-called “engine” of the global economy, has warned that demand for imports is waning in the face of a slowing economy and the threat of weaker export sales to three of its largest markets is an obvious concern for the Japanese government.

The Bank of Japan is also leery of recent actions by both the U.S. Federal Reserve and the European Central Bank. The Federal Reserve has not only maintained a near-zero interest rate policy for over two years now, it has actually committed to holding the line on future rate hikes until late 2014.

The ECB brought in back-to-back rate cuts last November and December to reduce the benchmark lending rate to 1 percent in an attempt to boost economic growth and stave off the threat of a Eurozone recession. The low interest rate policy embraced now by both central banks is weighing down both the euro and the dollar thus compounding the Bank of Japan's currency dilemma.

Finally, keep in mind that with so much uncertainty, investors are becoming increasingly nervous and the hunt is on for a “safe harbour” destination in which to ride out a possible economic storm. Traditionally, the yen has served as a dependable store of value with its long history of almost continuous gains. Should investors turn to the yen in response to a worsening situation in Europe, for instance, the resulting demand could boost the yen even further.