STERILIZED FX INTERVENTION:

THE EXEPERIENCE OF JAPAN

SHARON CHOO | DIV TENG | SHAUN CHIA | TEE BENJAMIN

CONTENT OUTLINE
1) Key Issues relating to sterilized FX intervention 2) Japans experience in using sterilization
Approach taken through history Effectiveness of Intervention efforts

3) Lessons learnt in exchange rate management

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

KEY ISSUES FX STERILIZATION

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

WHAT IS STERILIZATION?
When authorities simultaneously or with a very short lag take actions to offset or sterilize the effects of a

change in official foreign asset holdings on the domestic monetary base.

OBJECTIVE: Isolate domestic monetary system from activities in the foreign exchange market.

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

WHY USE STERILIZATION?

Objective of Central Bank:
Maintaining Price Stability

Controls money supply through i/r (minimize inflation) Managing foreign reserves
(exchange rate)

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

HOW IS STERILIZATION DONE ?

CB carries out equal foreign and domestic asset transactions in opposite direction so as to keep domestic money supply unchanged.

Source: Sarno, Lucio, and Mark P.Taylor. 2001.Official Intervention n the Foreign Exchange Market: Is It Effective and, If So,How Does It Work? Journal of Economic Literature 39(3), pp. 839868.
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

HOW IS STERILIZATION DONE ?

Illustration of how the CB balance sheet is maintained and effect on Monetary Base

3/26/2012

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

THEORETICAL FRAMEWORK
for sterilized FX intervention:

Sarno & Taylor (2001) sets out two theoretical explanations

1) Portfolio Balance Channel 2) Signaling Channel (Market Expectations)

Sarno, Lucio, and Mark P.Taylor. 2001.Official Intervention n the Foreign Exchange Market: Is It Effective and, If So,How Does It Work? Journal of Economic Literature 39(3), pp. 839868.
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

PORTFOLIO BALANCE CHANNEL

Public sees foreign assets as imperfect substitutes Following intervention against the YEN (Sell ), public

finds itself holding larger share of YEN assets At prevailing exchange rates this induces people to sell extra YEN to rebalance their portfolio
Sale of YEN assets would cause the ER to fall ( depreciates)

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

SIGNALING CHANNEL
Intervention conveys a signal that changes public expectations toward a future exchange rate

Sees signal as reflecting a change concerning future monetary policy or economic fundamentals As expectations change, ER moves in tandem
NOTE: As US & Japan maintain unrestricted capital flows, short term securities are highly substitutable, giving more credibility to the signaling channel as the theoretical basis for sterilization.

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

FREE MARKET v GOVT INTERVENTION

Should the central bank intervene or let the free
market decide on the exchange rate? Source of stability or more volatility? Cost? Implications? Impossible Trinity?

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

THE JAPANESE EXPERIENCE:

APPROACHES & EFFECTIVENESS

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

INSTITUTIONS INVOLVED
MINISTRY OF FINANCE (MOF) Determines intervention policy (FX policy) BANK OF JAPAN (BOJ) Determines whether sterilization takes place

Responsible for Fiscal Policy (Tax + G)

Acts as ministrys agent in conducting actual sterilization operations

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

HOW INTERVENTION IS DONE IN JAPAN

Ministry of Finance raises necessary funds for foreign exchange through sale of short-term government bills. Yen-funds obtained deposited in FEFSA (foreign exchange funds special account

BOJ given authority to use funds from FEFSA to carry out FX market operations
NOTE: As bills are issued before actual FX operations it implies that Japanese FX intervention activity is automatically sterilized

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

OVERVIEW OF JAPANESE INTERVENTION

Source: Data from World Bank: World development Indicators

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

OVERVIEW OF JAPANESE INTERVENTION

4 Main Episodes of Japanese Intervention Activity:

1975 1978 1985 1990

1991 1998 2003 2004
STATE OF ECONOMY OBJECTIVES

APPROACH
EFFECTIVENESS
LESSONS ON STERILIZATION

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LEARNING TO FLOAT (1973 1979)

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

LEARNING TO FLOAT (1973 1979)

Source: Data from World Bank: World development Indicators

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

LEARNING TO FLOAT (1973 1979)

STATE OF THE ECONOMY

Collapse of Bretton Woods Fixed ER system in 1971 Appreciation of the YEN from 308 = 1USD (1971) to 250 = 1USD (1977)
Moderate economic growth and accumulation of trade surpluses

Amidst two oil shocks in 1973 and 1979

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

LEARNING TO FLOAT (1973 1979)

APPROACH

First period of prolonged intensive intervention (Selling Yen) in 1977:

To prevent sharp appreciation of the YEN which crossed 250=1USD in Nov 1977

Coordinated intervention efforts with central banks of US/Germany & Switzerland in selling Yen.
Pattern reversed in 1979 as YEN began to depreciate with the second oil shock in 1979
KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

INTRODUCTION

LEARNING TO FLOAT (1973 1979)

OBJECTIVES & EFFECTIVENESS

Intervention was small and frequent To reduce ER volatility and to prevent excessive sudden appreciation of the YEN.
Successful in smoothing operations, limited in success in preventing LR appreciation of the YEN.

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

FROM PLAZA TO LOUVRE (1985 1989)

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

SECOND PERIOD: 1985 - 1989

Source: Data from World Bank: World development Indicators

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

FROM PLAZA TO LOUVRE & BEYOND (1985-1989)

STATE OF THE ECONOMY

Plaza Accord signed on 22 Sept 1985 to correct overvaluation of the USD. Following agreement, YEN appreciated sharply from 240=1USD (Sept 1985) to 200=1USD (Nov 1985)

Source: Datastream (London closing rates); Yen/Dollar Exchange rate (16 Sept 13 Dec 1985)
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

FROM PLAZA TO LOUVRE & BEYOND (1985-1989)

STATE OF THE ECONOMY

With sufficient appreciation achieved, authorities attempted to achieve ER stability without success. Moved to conclude the Louvre agreement in Feb 1987, with G-6 countries to cooperate closely to stabilize ER Joint intervention appeared to keep ER within a target zone (1987) but soon appeared fruitless as the markets no longer believed the credibility of policy coordination.

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

FROM PLAZA TO LOUVRE & BEYOND (1985-1989)

APPROACH
PURCHASE OF $s

Large, frequent interventions

37 days (out of 169)
Source: IMF, International Financial Statistics

EFFECTIVENESS

Limited in success Ineffective after 1988

Feb Oct 1987

Source: Nihon Keizai Shinnun; Funabashi (1988)

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

FROM PLAZA TO LOUVRE & BEYOND (1985-1989)

IMPLICATIONS

During period of appreciation following the Plaza accord, capital controls were swiftly relaxed:
In May 1987, as they tried to FIX ER within the particular band, they could not turn to capital controls

Sharp appreciation of the YEN also meant severe deflationary pressures, forced BOJ to turn to easy monetary policy (Cut I/R) to stabilize the YEN and expand domestic demand Policy which was too loose, too fast resulted in asset price inflation through 1990 and subsequent burst bubble in 1991.
KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

INTRODUCTION

FRAGILE RECOVERY : (1991 1995)

& (1995 1999)

Source: Data from World Bank: World development Indicators

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

FRAGILE RECOVERY : (1991 1995)

STATE OF THE ECONOMY

& (1995 1999)

Following the bursting of the asset price bubble in 1991, slow economic growth & stagnation Reduction of I/R from 4.5% in 1991 to 0.5% in 1995 Period characterized by spectacular YEN appreciation from 140=1USD (Apr 1991) to 80=1USD (Apr 1995) and depreciation back to 146=1USD (Apr 1998)

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

FRAGILE RECOVERY : (1991 1995)

APPROACH
Distinct differences in intervention strategy before and after 1995.

& (1995 1999)

Before 1995: Small & Frequent

After 1995: Large & Infrequent Coincided with change of leadership: Dr Sakakibara Mr Yen appointed in June 1995
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE

Feb Oct 1987

LESSONS ON STERILIZATION

FRAGILE RECOVERY : (1991 1995)

BEFORE 1995

& (1995 1999)

In March 1995, market pressures forced the YEN to appreciate beyond the 90 mark, and the authorities intervened on 21 days out of 23 days. Despite selling nearly 500 billion YEN, authorities were unable to keep the YEN from appreciating to 80=1USD.

Swift move of YEN attributed to delta hedge funds

Coincided with auto-trade disputes between Japan & US.

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

FRAGILE RECOVERY : (1991 1995)

AFTER 1995

& (1995 1999)

After appointment of Dr Sakakibara, interventions were less frequent and extremely large in comparison Intervention conducted in the same direction as the market v opposing the market

He believed previous efforts failed because of the predictable nature of the interventions and could not change market sentiments
On 8th September 1995, authorities made a successful push to bring the ER across the 100 mark
KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

INTRODUCTION

FRAGILE RECOVERY : (1991 1995)

& (1995 1999)

APPROACHES TOWARD INTERVENTION

Lean AGAINST the wind strategy

Putting a break on trend of ER movements a. Reverse the trend

b. Slows down the trend

Lean IN the wind strategy

Intervention in the same direction as the trend a. Hasten the return to normal level
b. Make sure direction continues

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

FRAGILE RECOVERY : (1991 1995)

EFFECTIVENESS

& (1995 1999)

Using a general test criterion:

Whether following an MOF operation, exchange rate moves in the desired direction or at least slows the movement in the undesired direction.
First Period Second Period

Days of Intervention
Between Interventions

165 days
6 days

49 days
49 days

Median Amount
% Success

$348 Million
27.9%

$3,984 Million
51.2%

Source: Chaboud, Alain P. and Owen F. Humpage, An Assessment of the Impact of Japanese Foreign Exchange Intervention: 1991-2004. Board of Governors of the Federal Reserve System, International Finance Discussion Papers, No. 824, January 2005.
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

THE GREAT INTERVENTION (2003 -2004)

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

THE GREAT INTERVENTION (2003 2004)

Source: Data from World Bank: World development Indicators

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

THE GREAT INTERVENTION (2003 2004)

STATE OF THE ECONOMY

In 2003, the Bank of Japan intervened vigorously to reduce the value of the YEN. Motivated by the perception that an excessive rise in the YEN would hinder economic recovery by reducing export competitiveness

35 trillion YEN sold between Jan 03 and Mar 04

Massive intervention led to a substantial increase in Japanese foreign reserves to more than $800 billion.
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

THE GREAT INTERVENTION (2003 2004)

APPROACH

Unilateral purchase of US$.

Stealth intervention Extremely large and frequent Median amount of $1,753 million Days between intervention = 3 days
Source: Japanese Ministry of Finance

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

THE GREAT INTERVENTION (2003 2004)

EFFECTIVENESS

Relatively successful during first 8 months of 2003 (stability) However, effects appeared to be temporary.
LT appreciation of the YEN from Oct 03 despite greater intervention
122
115

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

OVERALL EFFECTIVENESS OF STERILIZATION

KEY OBSERVATIONS

Success of sterilized Intervention dependent on: 1. Whether intervention was expected 2. Whether intervention was coordinated or unilateral

3. Size of the Intervention 4. Frequency of the Intervention

NOTE: Most of these factors are related to whether sterilization is able to successfully influence market expectations (Ee)
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

COSTS & IMPLICATIONS

How sterilized intervention transcended to the broader economy
Japan succumbed to international pressures in allowing its currency to float. Yen appreciated strongly. Relaxation of capital controls thereafter Affected Japans exporters competitiveness heavily dependent on CA of goods (relative profits of exporters drop when appreciated) Central Bank conducts sterilized intervention to prevent appreciation of to help exporters
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

COSTS & IMPLICATIONS

What Japan did not foresee
Concurrently to avert a recession, loose monetary policy (I/R) adopted Capital inflows and loose monetary policy caused asset bubble burst Deflationary pressures in the economy. Citizens have high propensity to save. Even at I/R near to 0, unable to stimulate economy Weak economic growth, deflationary pressures still felt today
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

LESSONS IN USING STERILIZATION

TAKEAWAYS FOR JAPAN IMPLICATIONS FOR CHINA

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

LESSONS IN USING STERILIZATION

Lessons: Japans Intervention Experience If fundamental factors affect the markets view of the ER, intervention is usually ineffective
Eg Large trade surpluses with US and GDP growth due to growing Japans export industry If interventions are predictable in nature, market will adjust itself to beat the interventions Expected size and time of intervention

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

LESSONS IN USING STERILIZATION

Lessons: Japans Intervention Experience
Importance of CB in managing the impossible trinity dilemma Sudden relaxation of capital controls not desirable

Coupled with a decrease in interest rates to stimulate economy in averting a recession

Loss of control of monetary independence following
decision to float ER and relax capital controls

Double source of pressure for currency appreciation.

Fuels inflation and asset bubble
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

LESSONS IN USING STERILIZATION

Similarities between 70s Japan and present China

Nature of economy
ER System

Export oriented
Fixed ER with strict capital controls

Current Account Status

Large and persistent Current Account surpluses from trade, particularly US

RMB seen as undervalued.

International view on seen as undervalued before & following Real ER (REER)

collapse of BWS. International pressures to revalue ER.

International pressures to revalue ER.

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

LESSONS IN USING STERILIZATION

Going Forward: How should China revalue its currency? Not to succumbed to international pressures Immediate and steep revaluation of ER dangerous and risky
Gradual shift away from current fixed exchange rate intervention and capital controls as Chinas economy grow

Give up sovereign monetary independence if it decides to adopt a free floating currency with free capital movement
Prevents rapid inflation and domestic problems in the country
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

LESSONS IN USING STERILIZATION

Was Japan profitable in its Intervention? Why no Quasi Fiscal Cost?

Free Capital Flows! - Boon or Bane?

- Stimulate FDI or cause excessive speculation?

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

STERILIZED FX INTERVENTION:
THE EXEPERIENCE OF JAPAN
SHARON CHOO | DIV TENG | SHAUN CHIA | TEE BENJAMIN

Links
Key Issues
Introduction to FX Sterilization Portfolio Balance Signaling Channel

Japans Experience
How Intervention is Done

Lessons Learnt
Lessons: Japans Intervention Experience Similarities: Japan v China How should China revalue its currency

Overview of Japans Intervention - 1975-1978 - 1985-1990 - 1991-1998 - 2003-2004

Overall Effectiveness Costs and Implications

INTRODUCTION

KEY ISSUES

JAPANS EXPERIENCE

LESSONS ON STERILIZATION

REFERENCES
Ito, T (2003). Is foreign exchange intervention effective? The Japanese experience in the 1990s. In Monetary History, Exchange Rates and Financial Markets, Vol. 2, P Mizen (ed.), pp. 126153. Cheltenham, UK: Edward Elgar.
Fatum, R and M Hutchison (2005). Foreign exchange intervention and monetary policy in Japan, 20032004. International Economics and Economic Policy, 2, 241260. Fatum R, Hutchison M. (2006). Effectiveness of official daily foreign exchange market intervention operations in Japan. Journal of International Money and Finance 25: 199219.

Takagi, S. (2008). Managing Flexibility: Japanese Exchange Rate Policy, 1971 2007, Exchange Rate Systems and Policies in Asia, Stallion Press, Singapore Chaboud AP, Humpage OF. (2005). An assessment of the impact of Japanese foreign exchange intervention: 1991 2004. Board of Governors of the Federal Reserve System, International Finance Discussion Papers, No. 824, January.
Sarno, Lucio, and Mark P.Taylor. (2001).Official Intervention in the Foreign Exchange Market: Is It Effective and, If So,How Does It Work? Journal of Economic Literature 39(3), pp. 839868.

Meyer Claude (2007). Should China revalue its curreny? Lessons from the Japanese Experience Groupe d/Economie Mondiale, (GEM) , SciencePo, Policy Brief 2008, April Ito, T. (2007), Myths and reality of foreign exchange interventions: an application to Japan. Int. J. Fin. Econ., 12: 133154. doi: 10.1002/ijfe.336
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

Appendices: BoJ 2011 Intervention

STATE OF THE ECONOMY

On 11 March 2011, the Thoku earthquake and tsunami occurred incurring an economic lost of US$235billion Japan being export oriented needs to maintain a competitive exchange rate Japan current account surplus makes it most reliable a currency to keep in comparison to Euro (debt crisis) and RMB (wariness on growth sustainability)
http://seekingalpha.com/article/318114-2012-yen-outlook-expecting-strength-from-boj-interventiongloominess-in-europe INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

Appendices: BoJ 2011 Intervention

APPROACH
Unilateral purchase of US$. Delayed announcement (stealth)
Extremely large

Repeated attempts

Statistics from http://www.boj.or.jp/en/statistics/pub/boj_st/index.htm/

INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

Appendices: BoJ 2011 Intervention

EFFECTIVENESS

Only Oct 10 & Sep 11 had an immediate depreciation of currency However objective is to slow down & provide direction 2 of 4 remaining interventions had a reversal in direction within 2 months
INTRODUCTION KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

Appendices: BoJ 2011 Intervention

IMPLICATIONS

The interest rates per annum remained at 0.3%1

(no monetary independence) Managing the challenges of the Impossible Trinity: USD vs Yen
82.4878 (25 Mar 12)

I/R from http://www.boj.or.jp/en/statistics/pub/boj_st/index.htm/

KEY ISSUES JAPANS EXPERIENCE LESSONS ON STERILIZATION

INTRODUCTION