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1 May 2013 CFA Institute Journal Review

The Great Intervention and Massive Money Injection: The Japanese Experience 2003–2004 (Digest Summary)

  1. Rajiv Kalra

Japan implemented large-scale monetary intervention during 2003 and 2004 to stimulate its economy when lowering interest rates alone had not been adequate. The authors show that the increased money supply that resulted from unsterilized currency interventions had consequences for investor expectations about future inflation when the economy recovered. As a result, investors’ expectation of increasing inflation affected the value of the Japanese yen.

What’s Inside?

To put downward pressure on the yen, Japan engaged in large-scale selling of yen and buying of U.S. dollars from the beginning of 2003 until early 2004—a period that is called the “Great Intervention.” Countries engaging in currency interventions often sterilize the monetary effect through open market operations that increase liquidity in the system by buying financial assets, such as bonds denominated in the local currency, using local currency as payment. The authors find evidence that suggests the Bank of Japan intentionally did not immediately sterilize the yen-selling intervention because it wanted to keep the current account balances of commercial banks at a high level. In addition, their analysis reveals that even though interest rates were near zero, the unsterilized intervention had a greater impact on the yen/dollar exchange rate than a sterilized intervention would have had.

How Is This Research Useful to Practitioners?

Although the overnight call money rate was near zero, the Bank of Japan (BOJ) initiated a policy of quantitative easing in 2001 to further stimulate economic growth. The objective of the policy was to stimulate demand by providing more liquidity to banks. The current account balance level was initially set at ¥5 trillion. This target level was steadily increased, until it reached ¥30 trillion to ¥35 trillion in January 2004.

During the time of quantitative easing by the BOJ, the Japanese Ministry of Finance engaged in massive selling of yen from January 2003 to March 2004 to put downward pressure on the yen/dollar exchange rate. The frequency of the intervention increased extraordinarily from once every 40 business days to once every 2 days.

It is not unusual for developed economies to enter the foreign exchange markets to affect their currency values. But the intervention in the currency market is usually almost entirely offset (sterilized) by the monetary authorities. The authors find that only about 60% of the yen supplied to the market during the Great Intervention was sterilized by monetary operations by the BOJ and that 40% remained in the market for some time. The authors suggest that the BOJ intentionally chose not to sterilize the entire intervention because it wanted the current account balances of banks at the BOJ to stay at a high level. Although the increased money supply did not affect the interest rate, it affected the yen/dollar exchange rate more than it would have if the interventions were fully sterilized. From this finding, the authors surmise that investors expect that an increased level of money supply is going to lead to higher inflation when the economy recovers than would occur with a sterilized intervention.

How Did the Authors Conduct This Research?

The authors use a sample of observations from January 1992 to March 2006. The sample is divided into periods before and after 19 December 2001, the date on which the BOJ changed its policy goal for the current account balance from a particular target level to a target range. They conduct a correlation analysis between the level of current account balance at the end of a day (t) and the value of yen sold/dollar purchased two days prior (t – 2). The intervention on Day t – 2 is used to control for a two-day settlement period for currency transactions. Although there is no correlation during the first period (before 19 December 2001), a weak correlation is found during the second period. A regression analysis reveals that there is no strong evidence to suggest that interventions in the first period were not completely sterilized. But it does reveal that about 60% of the values of foreign-exchange interventions were sterilized immediately, whereas 40% were not. The authors find that interventions totaling ¥35 trillion were executed during the Great Intervention. Interestingly, the current account balance at the BOJ increased by ¥13 trillion (40% of the value of the interventions) during this period.

The current account balance target range was updated only five times during the Great Intervention period, but the yen-selling intervention took place over 123 days, which indicates that not all currency interventions were immediately sterilized. Unlike in preceding time periods when the yen selling was sterilized within two days, the authors find that the yen supplied during this period remained in the market for much longer. They determine that the unsterilized interventions had a greater impact on the yen exchange rate than would have occurred if the interventions were sterilized. They infer that investors update their expectations about the future money supply and inflation if the interventions are not fully sterilized.

Abstractor’s Viewpoint

During times of liquidity traps, increased money supply does not have any impact on interest rates. Nevertheless, the increased liquidity can help stimulate the economy. But an increased money supply is not without consequences. As the authors suggest, if investors perceive that the increased money supply resulting from an unsterilized currency intervention is likely to remain in the economy for some time, their expectation is that inflation rates will be higher in the future, which affects the currency value more than it would have if the intervention had been sterilized.

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