How Japan and Switzerland Could Reshape the Currency Markets
Japan and Switzerland are facing the same threat to their economic health. And so far, every step they’ve taken to make things better has only made them worse.
But there is one way they could conceivably get out of this mess. And even though no one is talking about it yet, a mere hint of the possibility could send China-sized shockwaves throughout the global currency markets.
Their joint problem is a strengthening currency. As a country’s currency strengthens, domestically manufactured products become more expensive when shipped abroad – making them uncompetitive in foreign markets. That’s bad for Switzerland and Japan, which depend of export income for growth.
Right now the situation for Japan is so bad that Bank of Japan Governor Masaaki Shirakawa left the economic symposium in Jackson Hole, Wyo., to meet with the prime minister and fellow central bankers.
The Japanese yen (JPY) has strengthened by more than 10% since May against the US dollar. But up till now, Japan has been loath to intervene. Instead it has employed verbal intervention – promising action without actually taking action, a practice that has been used quite often in the last couple of weeks. Clearly it isn’t working, making actual intervention a possibility…even though that might be doomed to fail, too.
The last time the bank stepped in was at the end of the first quarter in 2004. Hoping to stop a 15-month bull run in the yen, central bankers applied a $400 billion brake.
At first, it worked. The Japanese yen weakened for a couple months following the intervention. But it might not work again. Investors already anticipate such a move, so the effectiveness of such a strategy would fall to the wayside – likely to only delay another inevitable advance of yen strength.
On Aug. 30, the Bank hashed out a new monetary plan. It extended a loan facility to institutions in need. The existing facility was expanded to 30 trillion yen (approximately $350 billion) from 20 trillion. The duration was also extended, with a percentage of the 30 trillion yen pie being available for as long as six months.
Although good in theory, the loan facility expansion will do little to deter current speculation in the yen. Setting aside market expectations, the loan facility is far too small to deter yen speculators at this stage in the rally. The 10 trillion yen boost is only one-third the amount used to in the 2004 intervention.
Back towards Europe, Switzerland finds itself in a similar situation. Like the yen, the Swiss franc (CHF) has also strengthened against the greenback. Since June 1, the franc has appreciated by 13% against the US dollar, falling to within 2 cents of a one-for-one exchange with the US currency.
Things are even worse compared to the European Union’s euro (EUR). The Swiss franc has risen to a record-high exchange rate – trading as high as 1.2891 francs per euro. The situation places enormous pressure on the Swiss export market, creating a monetary headache for Swiss National Bank President Philipp Hildebrand.
And just like Japan, direct market intervention may not be enough to solve the problem. Since the beginning of the year, Swiss National Bank policymakers have spent almost 200 billion euros markets to stem franc’s rise – with about 37% being applied in May 2010 alone. Reserves grew 50%, pushing it from the world’s 13th-largest reserve holder to the 7th-largest.
Yet the franc continued to strengthen. In fact, speculation has remained so strong that the Swiss bankers abandoned their intervention efforts at the end of June.
So, more currency intervention doesn’t look like it will help either Japan or Switzerland – at least not separately. But what if they joined forces?
A coordinated effort by both central banks may be just enough to cool down FX speculation – helping the US dollar gain ground against the Swiss franc and Japanese yen. Traders and investors bullish the yen and franc would have to contend with a massive combination of foreign currency reserves. Together, both Japanese and Swiss reserves would rank second only to China – the world’s largest holder of foreign exchange reserves.
But more importantly, the combined size of both countries’ reserves would overshadow the size of UK reserves when the sterling came under attack in 1992. As speculators hit sterling markets en masse that year, UK monetary authorities were only able to access approximately 27 billion pounds (or roughly $50 billion) in foreign currency reserves to ward off traders. In the end, it proved to be too little as policymakers were unable to support the underlying cable.
Although circumstances were different – traders bet for a collapse in the sterling (GBP) rather than a surge as in the yen and franc – the underlying basis of speculation remains the same. With a total of over $1.2 trillion to work with, Swiss and Japanese central bankers may be able to deter speculative appetite in the short term.
A united front would also raise the specter of further collusion with other countries. Let’s face it – anything of this magnitude is far from becoming a reality. But the possibility of it actually happening would be enough to make FX traders reconsider their positions. This would be especially true if the United States and Europe were added to the mix. The likelihood of four international central banks forming an alliance to combat FX speculation would take on a different meaning in the market. Central bank rhetoric would be taken more seriously – keeping every investor and trader on his or her toes.
Unfortunately, until the Swiss National Bank and the Bank of Japan act as a coalition – or enact bolder moves other than just plain vanilla FX intervention – yen and franc strength will linger on for the rest of the year. Speculators require more than just jawboning and weaker monetary promises in turning their opinions. Modern central banks aren’t able to completely control their respective currencies.
But a surprise and gutsy move by both bodies may be just enough to slowdown any FX appreciation – and support a turnaround in the market.