The G-7 finance ministers acted last week to halt the strengthening of the yen and dampen market volatility in the face of the twin tragedies in Japan. A key question is, why would the yen strengthen? Four hypotheses have been advanced. First, it is thought that insurance companies are repatriating yen in anticipation of the need for funds to settle the massive claims associated with the quake and tsunami. Second, is the unwinding of the carry trade, or international arbitrage, in which traders borrowed yen at very low rates and invested the funds in higher-yielding claims elsewhere. Third, is speculation by currency traders. Finally, there is the sudden demand for dollars by Japanese citizens.
Putting these issues aside, the public reports state that central banks, such as the Bank of Japan and the Fed, began selling yen to increase the supply and weaken the yen. In fact, the yen has weakened slightly since the announcement of the coordinated effort. What is a bit misleading, especially as far as the U.S. is concerned, is that there is actually no indication that the Federal Reserve has engaged in any foreign currency intervention on its own, nor is there any indication in available press releases that it will do so. The reason is arcane. Remember that the announcement on Friday, March 18 was a move by Treasury officials, not central banks. In the U.S., exchange-rate policy has traditionally been the prerogative of the Department of the Treasury, not the Federal Reserve. Such interventions are executed out of the Treasury’s Exchange Stabilization Fund that was created by the Gold Reserve Act of 1934, when the government made it illegal for anyone, other than the Treasury, to own gold; and this included the Federal Reserve, whose gold holdings were transferred to the Treasury in return for gold certificates. Part of the confusion in the U.S. media as to which entity is making foreign exchange interventions results because the Federal Reserve executes the Treasury’s purchases and sales of foreign exchange as agent for the Treasury through the Federal Reserve Bank of New York. Additionally, from time to time as interventions are authorized, the Federal Reserve has, usually at the request of the Treasury, executed parallel transactions from its own accounts.
What if there aren’t enough yen to sell to get the currency to the desired level? It is estimated that sales would need to be $20 billion or more to have a material effect on the value of the yen. As of the end of February, 2011 the Exchange Stabilization Fund stood at $104 billion, with assets consisting of three major types: Special Drawing Rights (from the IMF) of $58 billion, U.S. Treasury obligations of $20 billion, and foreign exchange reserves, of which $14.5 billion were euros and about $12 billion were Japanese yen.
But this is not the total of resources within the U.S. that are available to help support the yen. Moreover, one would expect that only a few billion would come from the Exchange Stabilization Fund, since the intervention was to be a coordinated effort by the G-7. Finally, remember that the Treasury can also request parallel or supporting transactions from the Federal Reserve out of the System’s own resources.
The Federal Reserve presently holds about $119 billion in foreign exchange assets, but most importantly, it has swap lines outstanding that were established with other central banks during the financial crisis. In setting up a swap line with the Bank of Japan, for example, the Fed would deposit dollars in the BoJ’s account with the Fed, and in return the Fed would receive an equivalent dollar-value deposit in yen at the BoJ. These swap lines mean that the Bank of Japan can provide essentially an unlimited supply of yen in return for dollar deposits that the Fed could use to support intervention activities if needed.
The minutes of the FOMC’s January 25-26, 2011 meeting detail and reaffirm these swap arrangements, including permitting a number of named central banks to draw dollars in return for their own currencies – in this case the Bank of Japan could “borrow” dollars in exchange for yen. The minutes also reproduce not only the authorization for the New York Fed to engage in foreign currency transactions but also provide details of the circumstances under which such transactions can take place (through the Foreign Currency Directive), and in addition lays out the procedures and oversight of those transactions ( thorough “Procedural Instructions with Respect to Foreign Currency Operations”). In short, the Bank of Japan and the U.S. have in place both the actual and potential resources to engage in virtually any foreign exchange activities they desire, should intervention be necessary.
