Admittedly, the initial decline in the dollar last year was actively encouraged by an American administration eager to force trade concessions from the Japanese. But once the dollar moved into freefall below Y95, the American tone changed markedly. The worry has been that the strength of the yen would go much too far, tipping the Japanese economy into deeper recession, and threatening the stability of the financial system, not just in Tokyo but throughout the world. For several months - at least up until last last week - the major central banks, and even their political masters, have worked together to get the yen back under control.
The potential importance of stabilising the currency markets at levels justified by economic fundamentals was demonstrated last week, when the sudden resurgence in the Japanese currency, and the associated decline in the dollar, triggered a general collapse in global bond and equity prices.
We know that official attempts to stabilise a currency at the wrong level are doomed to failure. So what level should the central banks shoot for in the case of the yen? The standard model for valuing an exchange rate nowadays is illustrated in the graph. There are three main components.
First, we need to choose a fundamental equilibrium exchange rate (or FEER) which will produce balance of payments equilibrium between the US and Japan in the medium term. The market should always expect the yen/dollar rate to track back towards this rate over long periods. Historical data suggest that on average it takes about seven years to get back to this long-run equilibrium after any shock. Unfortunately, we cannot be at all sure where the FEER is at any point in time, but recent estimates suggest that the FEER may be around Y/$ 100-110. Let us call it Y/$ 105.
Second, the equilibrium level for the exchange rate today relative to the FEER will depend on the real interest differential between the US and Japan. At present, the real long bond yield in the US is 3.6 per cent, while that in Japan is 2.7 per cent - a differential of 0.9 per cent in favour of the US. This means that the equilibrium dollar exchange rate today must be higher than the FEER so that the dollar can adjust to the FEER over 7 years - this is the "overshooting" part of the model.
If the dollar needs to adjust down by 0.9 per cent a year for 7 years towards its FEER (by the amount of the bond yield differential, for example), it can be 3.6 per cent above the FEER today. With the FEER at 105, this implies a an equilibrium exchange rate of about 109. The "bond yield adjusted equilibrium" Y/$ rate shown in the graph traces similar calculations back through time - obviously, when the real bond yield in the US is above that in Japan, this equilibrium rate is above the FEER and vice versa.
Third, we need to adjust for the fact that the market often requires a risk premium on top of the difference between bond yields. As the graph shows, the actual exchange rate differs from the "bond yield adjusted equilibrium" rate, sometimes by large amounts. This is because of the existence of these risk premiums, which apply when the market requires an excess return in one currency (usually the dollar) in order to be induced to hold it. When the actual exchange rate is below the equilibrium rate, the risk premium on the dollar is positive, and vice versa. On many occasions, large shifts in the exchange rate are caused by changes in the risk premiums, while the underlying fundamentals do not change. This is basically what has happened in 1994-95.
Examination of the graph reveals that there have been four phases in the Y/$ rate since 1990. Phase 1 (Jan 1990 to August 1991): The dollar traded a long way above its "equilibrium" because the market was demanding a risk premium on the yen, but this had disappeared by the autumn of 1991. The significant rise in the exchange rate in early 1990 was triggered by a large shift in bond yield differentials in favour of Japan; this was reversed in late 1990/early 1991.
Phase 2 (August 1991 to April 1992): The actual rate traded closely in line with the equilibrium rate, and was basically driven lower by the shift in real bond yield differentials in favour of Japan. There was no risk premium either way.
Phase 3 (April 1993 to April 1995): A large drop in the exchange rate was triggered entirely by a continuing and large increase in the risk premium on the dollar. There was little change in the equilibrium rate in the entire period during which the Y/$ rate moved from about 115 to about 80! This shows what damage changes in risk premiums can do to fundamental models for long periods.
Phase 4 (April 1995 to the present): A sudden recovery in the dollar was triggered by a collapse in the risk premium as fiscal, monetary and financial policy was adjusted in a major way in Japan. Again, there was no large change in the equilibrium rate.
The current Y/$ rate (around 100) is probably still below the short-term equilibrium; the difference is now about 9 per cent, compared with almost 30 per cent at the peak. But in view of the uncertainties in estimating both the FEER and the market's expectation of future real interest rates, this is not a very significant difference. The implication is that the main part of the yen's overvaluation has been corrected, and that the currency is now trading within tolerable distance of "equilibrium". A zone of Y/$ 100-110 would probably be optimal for the authorities, since this would be enough to resuscitate the Japanese domestic economy without uncorking too much American concern about the excess competitiveness of Japanese exporters.
What are the chances of keeping the yen in this optimal zone? Little active help can be expected from the Americans, so it is really up to the Japanese authorities. They will have their work cut out. So far, there has been little underlying improvement in the disruption of balance of payments between the US and Japan which was the main reason for the risk premium on the dollar in the first place. That risk premium could all too easily reassert itself, pushing the yen back up to dangerous highs.
In order to prevent this, the Bank of Japan will need to continue intervening in the currency markets - selling yen actively, consistently, and without regard for the further downward pressures this will cause on domestic interest rates in Japan. Currency intervention can work, provided that the Bank of Japan is really willing to continue flooding the domestic money markets with yen. If they are ready to do this, the yen can be stabilised, or even weakened further. But if they blink, the crisis will return.