Finance ministers and central bankers from the world's developed nations decided late on Thursday night to send a firm message to financial markets that they would not stand by and watch the yen continue to strengthen.What have the G7 agreed to do?
Finance ministers and central bankers from the world's developed nations decided late on Thursday night to send a firm message to financial markets that they would not stand by and watch the yen continue to strengthen.
The Bank of Japan began selling yen overnight to depress its value. Other central banks are expected to follow suit as their markets open through today, in a rare concerted move.
What prompted them to act?
Since the earthquake and tsunami hit last week, the Japanese currency had been getting stronger, and after London traders went home on Wednesday night it hit its highest level against the US dollar since the second world war at ¥76.25.
Not only is that a damagingly high level for Japan's export-led economy, it risked triggering the "volatility" in currency markets that central bankers hate to see.
But why was the yen strengthening when the Japanese economy is going to be hit by the crisis?
There are three likely reasons. The first is that Japanese insurance firms and other corporations are "repatriating" cash – exchanging their foreign-denominated holdings for yen – to pay for the cost of handling the crisis.
The second reason is the unwinding of the so-called "carry trade" – a popular investment strategy in which traders take advantage of ultra-low interest rates in Japan, by borrowing in yen and reinvesting the proceeds in some other, faster-growing stock market overseas – exchanging the yen for Brazilian real, New Zealand dollars, and so on.
Nervous investors may have started to reverse this bet in recent days, bringing their overseas investments back home, and strengthening the Japanese yen in the process.
A third and more depressing reason for the yen's move is pure speculation — investors betting, George Soros-style - though these days through complex financial instruments - on how the yen would move as a result of the crisis. Japanese deputy finance minister Fumihiko Igarashi said that these speculators are 'like sneaky thieves as the scene of a fire', who are capable of ruining the Japanese economy.
Who's driving the carry trade?
Much of it is overseas traders, but a considerable proportion comes from ordinary Japanese domestic investors – "Mrs Watanabes" as they are colloquially known in the financial markets.
Amid the past week's dramatic events, analysts believe Japanese investors may be showing more of a "home bias" – a tendency to want to hold their savings in their own currency. This is a common reaction in times of crisis, and could bring a wall of money flowing back into the yen.
Overseas investors may also be tempted to reverse the carry trade, if they judge that the knock to confidence from events in Japan – and the Middle East – mean that growth in emerging markets will be weaker than expected.
Why does all this worry the G7?
The wrenching aftermath of the collapse of Lehman Brothers collapse in autumn of 2008 showed that rapid movements in financial markets can very quickly transmit panic throughout the global economy. If the carry trade abruptly unwound, it could cause what economists call a "sudden stop," draining capital from riskier markets around the world, with real consequences for business and consumers on the ground.
What does a stronger yen mean for the Japanese economy?
It's bad news: Japan is heavily dependent on exports for generating even the meagre economic growth of the past few years.
Will the G7 succeed?
So far, the Bank of Japan's buying spree seems to have worked - the dollar was trading at ¥81.83 by Friday morning, more than 7% lower than the peak hit on Wednesday.
Currency intervention tends to work best when the markets are already at a turning point, and the Bank of Japan has intervened a number of times in recent years with limited long-term success.
Even the most brass-necked speculators may feel that trying to bet against every major central bank in the world is not a great plan; but the G7 policy is a high stakes one, because if they are seen to have failed, the consequences for market confidence could be catastrophic, particularly when central banks' aura of omnipotence has already been severely shaken by the credit crunch.
What will happen to the yen when the G7 selling spree is over?
Many analysts believe there are plenty of good reasons for the Japanese currency to weaken anyway, once the immediate crisis is over and there is more certainty about the fate of the nuclear reactors at Fukushima.
The Bank of Japan has already injected more money into financial markets in an extension of its long-running quantitative easing programme, and the costs of the crisis are likely to mean a further painful increase in the Japanese government's debt, which already stands at 200% of GDP. That should keep interest rates ultra-low for the forseeable future.
And while large-scale reconstruction efforts should eventually boost Japanese demand, in the short run widespread factory shutdowns and the loss of industrial capacity in the devastated regions will mean the Japanese economy is extremely weak. None of that will be good for its currency.
What does all this mean for us?
Both the Bank of England and the European Central Bank were edging towards raising interest rates to clamp down on inflation. But with confidence in global markets being severely tested by events in Japan and the Middle East, the return to "normal" monetary policy from current emergency levels is likely to be delayed. City traders have already pushed back their prediction of the first rate rise by the Bank of England from May to August.
Sourced from Heather Stewart
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