The Economics of Currency Intervention: Will the Recent Yen Intervention Succeed?
When you or I buy or sell a fiat currency, we have no direct bearing on its composition. However, when a central bank buys or sells its own currency it does have a direct impact on the currency’s composition. In buying or selling its own currency, a central bank alters the structure of its own assets and liabilities; hence, its currency becomes ‘good for’ different things.
In this article, I explore this peculiar aspect of currency interventions. In particular, I explore how this concept can help us understand the nature of recent interventions in the Yen. Depending on the progress of consensual thought, this understanding may prove profitable for the contrarian investor; traders may be foxed into the wrong positions based on their false premises about monetary matters. If this comes to pass, the contrarian may find profitable opportunities in assuming the other sides of their trades.
The Act of Intervening in Currencies:
When – say – the Bank of Japan intervenes in the foreign exchange markets, what does it do? Well, it increases its stock of liabilities (Yen notes & Yen Reserve Balances) in order to buy dollars. That is, the BoJ ‘prints’ Yen to buy dollars. Typically, those dollars are subsequently used to buy US Treasury securities. The net effect is that the BoJ increases the size of its balance sheet; thus, it has more stuff (additional dollars), but also has more claims on that stuff (printed Yen).
The Implications of the Profit-Motive:
One of the key contentions that I insights on greshams-law.com is: in order for a currency to be a well-functioning and viable currency, there must be a profit-motive in owning it. Indeed – unless there are onerous price controls – the market finds a way to allow a profit-motive. [Incidentally, periods of hyperinflation represent moments in time where such a profit-motive is dogmatically impeded.] In the particular case of fiat currencies, this means that they should trade at discounts to par. What exactly do I mean? I mean that – say – the Yen should trade in the market such that the entire volume of BoJ liabilities can only buy a proportion of the BoJ’s assets. In other words, the Yen should trade to reflect the fact that it’s only as good as what it’s backed by. For example, if each 100 Yen note were backed by 1 ounce of gold at the BoJ, who would pay more than 1 ounce of gold to get a 100 Yen note? Who would trade more than 1 ounce of gold for something that is only ‘good for’ 1 ounce of gold?
If this is true, then fiat currencies tend to trade at ‘discounts from par‘, and any expansion in the balance sheet of a central bank entails a dilution of its currency. A central bank (with an irredeemable fiat currency) always prints ‘more’ than it adds to it balance sheet. Only a well-trusted redeemable currency would trade at par; and such a currency would have the ‘green light’ for balance sheet expansions. The discount from par involved with irredeemable fiat currencies is the market’s way of saying ‘stop right there!’.
The Discount & The Effectiveness of Interventions:
The ‘discount from par’ is a market price. As with any other market price, it jumps and falls in every moment. It is my contention that this price can have enormous implications for the effectiveness of currency interventions (and any monetary policy for that matter). The greater the discount from par, the greater the extent of currency dilution. Conversely, the smaller the discount from par, the smaller the extent of currency dilution. Let’s go through an example or two to get this clear:
Suppose the Bank of Japan owned just 1 ounce of gold and had 100 yen issued (as a liability) against it. Further suppose that – on the market – 1 ounce of gold traded with 110 yen. The implication would be that the entire stock of Yen (100) could buy roughly 90% of the Bank of Japan’s Assets (1 ounce of gold). What if the Bank of Japan decided to increase its assets by 1 ounce? In order to do so, it would have to print 110 Yen notes. The result would be a Bank of Japan with 2 ounces of gold and 210 Yen outstanding. The ‘dilution’ amounts to 10 Yen here. But what if the market were – in aggregate – skeptical about the Bank of Japan? Say that – on the market – 1 ounce of gold traded with 200 yen. Then the BoJ would have to print 200 yen to end up with 2 ounces of gold. The result would be a Bank of Japan with 2 ounces of gold and 300 Yen outstanding against it. The ‘dilution’ amounts to 100 Yen here. A more profound discount from par entails a more profound dilution (for an irredeemable fiat currency).
Is the Bank of Japan ‘pushing on a string’?
Is it any wonder that the history of currency interventions is a history of failures? Currency interventions are usually implemented in response to an unpalatable rise in a currency. But such rises typically imply that the currency is already trading at a comparatively low discount; people are already engaged in the deflation/fear trade. In such environments, balance sheet expansions are less dilutive to the currency. So even if a central bank comes out with an impressively large intervention budget, it doesn’t matter – their assets will increase by almost the same amount. The irony of a central banker’s job is thus revealed; currency interventions only ‘work’ when they are completely unnecessary. And precisely when they’re ‘needed’ the most; they don’t ‘work’.
So, will the recent G7 intervention in the Yen work? My fear is that – given the way things are – it is unlikely to meet their perceptions of effectiveness. The earthquake and tsunami have – of course – already happened, and the ensuing ‘risk-off’ trade in Japan has already taken hold. The result is that the authorities will probably think up a huge nominal amount of Yen to sell for Dollars; only, it still won’t be enough to make a dent in the free market…
[The above is a hunch, and there are prospects that could change it. For one, if the nuclear situation were to drastically worsen, the calls for the printing press may be so fierce that the Yen could decline. The only thing is that – in this scenario – there would be a serious risk of profoundly destructive inflation.]
Implications for the Contrarian Investor:
The contrarian investor is not in the business of investing on internally-sourced ‘visions’ of the future. Rather, he/she is in the business of attempting to oppose the herd. The golden scenario for the contrarian is when the convictions of the herd are ferocious (about the future) and based on false premises. Depending on the course of consensual thought, there may arise opportunities to oppose certain trades (pertaining to the Yen). For example, there may be contrarian merit in opposing those who are convinced that the authorities can succeed in their interventions. Likewise – sometime in the future – there may be opportunities to short the Yen after a long-period of failed intervention (and a rising discount from par).
Central bankers are – typically – lagging in their foresight and subsequently subject to inevitable frustrations. Their normal job is virtually impossible for any man; so we shouldn’t be surprised that successful currency intervention is very rare. The folly of central planning in the monetary sphere extends to the endeavor of currency intervention. It is likely that they will fail in their endeavors for a long time. If they finally do debauch the Yen significantly, it may be way in excess of what they had in mind.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012