Intervention alone rarely turns currency

The US and Japan caught world markets by surprise by intervening in foreign exchange markets for the first time in three years…

The US and Japan caught world markets by surprise by intervening in foreign exchange markets for the first time in three years on Wednesday. That arcane and somewhat secretive process was used in an effort to influence the value of the yen and the dollar.

Q. The US Federal Reserve and the Bank of Japan intervened in foreign currency markets to boost the value of the Japanese currency, the yen. What did they do?

A. In many ways, currencies are like commodities, with their value determined by supply and demand. To halt the long-running decline in the yen's value, the New York Federal Reserve Bank - acting on behalf of its parent, the Federal Reserve Bank, which is the US central bank - bought a substantial but unannounced amount of the Japanese currency. At the same time, the Bank of Japan, that nation's central bank, sold dollars and bought yen. The purchases and the action's favourable psychological effect on the market caused the yen to rise 4.4 per cent against the dollar and the gains were maintained yesterday.

Q. Why should the US want to prop up the yen? Isn't a strong dollar good for the US? A. In general, a healthy currency is regarded as a plus for a country. However, the yen had become so weak that a further fall, for competitive reasons, might have caused China to devalue its currency. If that were to happen, other Asian nations already hard hit by last year's economic and financial turmoil would probably have seen their currencies fall as well. That, in turn, could have led to further economic upheaval in Asia and might have spilled over into world financial markets.

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Q. If the yen has been so weak, why did everyone wait so long to intervene?

A. Principally because intervention alone can rarely turn around a currency. Other action to change the fundamental reasons for a currency's weakness also is needed.

In this case, Japanese officials have agreed to take significant steps to deal with the huge amount of bad loans Japanese banks have on their books and to make other moves to stimulate their slumping economy.

Q. Who decides to intervene and how much money will be used to do it?

A. In the US, the Treasury Department (Department of Finance) and the Fed normally decide jointly to intervene, with the New York Federal Reserve undertaking the intervention in the market. The size of the intervention is determined by the collective judgment of how much money is needed to affect currency values. The co-ordination of this week's move with Japan was discussed between the two governments and central bank officials from the US and Japan.

Q. Will Japan and the US continue to intervene until Japan has begun reforming its banking system?

A. There could be further intervention, but certainly not on a daily basis. For instance, in 1995, when the dollar was weak and the yen strong, the New York Fed entered the market on eight occasions to buy dollars and sell yen and deutschmarks. All together, it bought about £4.69 billion worth of dollars.

But in such situations the effect of an intervention may reverberate in the currency market for some time. For most of this year, currency traders have made money betting against the yen. Some probably lost considerable sums this week as a result of the intervention and the yen's rally. Now, traders may be more cautious in placing their bets.

Q. Did the US government lose money, too?

A. No. The Treasury and the Fed aren't out to make a profit on interventions, yet they always do. When the dollar is very strong, as it is now, they receive many yen or deutschmarks in exchange for dollars sold. On the other hand, when the dollar is weak and yen or deutschmarks are sold, they get more dollars in return.