Bank of Japan Needs To Just Keep Holding Its Nerve

By: Milla Shaw in Forex Consultant on Jul. 25, 2011

Talk about it. Threaten it.

But the last thing the Bank of Japan should do is intervene.

So far, the central bank has done good.

Unlike its central bank neighbors in Korea, Thailand and the Philippines, the Bank of Japan has resisted temptation to halt its currency’s rally against the dollar, even though the yen has risen to a fourmonth high at Y77.88 and isn’t too far way for its record high of Y76.50.

The country’s trade, economy and finance ministers all sallied forth to express their concerns as the yen rose.

A strong yen is hardly what Japan needs as the country struggles to recover from the devastation of the March 11 earthquake and tsunami.

But, intervention now will only make matters worse.

First of all, the yen’s strength is largely due to dollar weakness, a trend that is entirely out of Tokyo’s control and one that could intensify if there isn’t an early solution to the U.S. debt ceiling negotiations.

Finance Minister Yoshihiko Noda recognized this in his comments by calling the yen’s move “onesided”.

Second of all, currency markets love to play with a line in the sand. If the Bank of Japan provided one around current level it could find itself committed to a longrunning battle to defend that level.

And, if it was eventually forced to give in to the speculators as central banks have often had to do in the past, the bank would lose credibility and have damaged its ability to defend the yen in the future.

In other words, in a battle with so much stacked against it the central bank has to be even nny than usual, despite the growing pressure from Japanese corporations for the authorities to wade into the market and help to promote exports with a weaker yen.

But, the best solution to achieve this is to keep the market guessing.

So far, this policy has worked.

The lamest evidence came early Tuesday when, as the dollar headed under Y78 and players became rvous about intervention, the yen came under sharp selling pressure on fears alone that the central bank may have come into the market.

For the moment, the downward pressure on the dollar against the yen is unlikely to subside.

Apart from monthend flows, which often include repatriation in favor of the yen, there is the growing risk that the U.S. will either default on its debt obligations or face a downgrade in its credit rating for not coming up with a convincing longterm solution.

All this looks distinctly messy, suggesting that investors will continue to dump the U.S. currency for some time to come.

However, there is good reason to believe that even in a worst case scenario that Bank of Japan patience would pay off and that the dollar slide will come to an end.

Despite all the talk that the dollar will suffer if Congress doesn’t come up with a comprehensive deal, economists at BNP Paribas remind us that a less comprehensive deal that reduces the level of fiscal drag would provide the economy with a vorable fiscal/monetary policy mix.

That is, the U.S. economy would probably recover ickly.

And for the dollar, that should be good news.

Then, there is also the question of diversification. Certainly, the trauma over the debt ceiling talks will only encourage central banks to sell their dollar reserves, especially if the U.S. loses its tripleA rating.

But, with the future of the euro still seen highly uncertain and with other major currencies unlikely to provide a large enough alternative, central banks would probably be loathe to drive the U.S. currency too much lower and seriously devalue the reserves they still hold in what is still the world’s largest reserve currency.

 

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