Sunday, February 17, 2013

Is Japan fighting a currency war?

Given that a war is „a state of usually open and declared armed hostile conflict between states or nations” or, more generally, “a struggle or competition between opposing forces or for a particular end“, what is a currency war?

The opposing forces are the different currencies; each state strives for having the currency that favors most the domestic economy. This usually means having a cheap currency that favors exports. More specifically, when exporters get paid in foreign currency, they can change it into relatively more (cheap) local currency. In the end, this makes local production less expensive.

What are the weapons of a currency war? They consist of selling local currency for foreign currency, thereby driving the price of the local currency down.

The case of Japan

Is Japan fighting a currency war? Does the country sell Yen to drive its price down? Let's look at the figures:

You can find an interactive version of these charts here.

Japan's foreign currency reserves (an approximate measure for selling Yen) and the JPY/USD exchange rate are in line. A correlation coefficient of 0.8419 and a coefficient of determination of 0.718094566 confirm a positive linear correlation but are at the lower end of what is statistically relevant.

It therefore seems likely that Japan sells its currency to push down its price.

This should favor Japanese exporters. After all, the more Yen they got for each USD the lower local costs will become. But do they really benefit?

You can find an interactive version of this chart here.

Yes, but less than I expected. At least, there is no significant correlation between the country's exports and its foreign currency reserves or exchange rate. This makes sense, as a country's exports should depend on many other additional variables than just a favorable exchange rate.

International Positions

How do the above findings compare with the recent G7 and G20 announcements on currency policies?

On February 12, 2013, the G7 finance ministers and central bank governors have declared:

We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates and to consult closely in regard to actions in foreign exchange markets. We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates. We agree that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability. We will continue to consult closely on exchange markets and cooperate as appropriate.”

On February 16, the G20 countries have added:

We reiterate our commitments to move more rapidly toward more market-determined exchange rate systems and exchange rate flexibility to reflect underlying fundamentals, and avoid persistent exchange rate misalignments and in this regard, work more closely with one another so we can grow together. We reiterate that excess volatility of financial flows and disorderly movements in exchange rates have adverse implications for economic and financial stability. We will refrain from competitive devaluation. We will not target our exchange rates for competitive purposes, will resist all forms of protectionism and keep our markets open.“

Are you convinced?