Japan as the new Switzerland... ... just as it becomes the new China, which is no longer the old China. Ok? Probably not, but we may as well go through the argument anyway. The idea is that Japan, sick of yen strength which it struggles to combat in a risk-driven world, sticks a Swiss-style floor under its currency. It's not the newest idea and there are suggestions that a de facto floor is already in place anyway but the argument, from Société Générale, is worth running through as there is certainly more chance of an explicit floor being announced now than there was when we last visited the idea. SocGen start on a respect-worthy point: that there is no simple way to measure how over or undervalued the yen might be. While the Japanese currency has soared versus the euro and dollar in particular since 2008, there has not been a clear trend in the real effective exchange rate over the longer term. However, they go on to argue that there is some clear evidence that Japan has been hurt by yen strength anyway. They point first to exports, which fell far more than those of comparable economies or indeed world trade as a whole, and also failed to recover much of the loss thereafter, suggesting the yen's external value may be too high: They also point to the 2011 earthquake and Tsunami (with our emphasis): First, the destruction of part of Japan's capital stock implies a lower level of productivity and hence a lower real exchange rate. Second, and more importantly, the shutdown of Japan's nuclear power plants, and the subsequent decision to completely abandon nuclear power, implies a permanently higher propensity to import. This also implies a lower equilibrium exchange rate. So, assuming that Japan needs to fight yen strength, and it's pretty clear the Japanese think they do, how then should they go about it? Numerous voices, including members of its own board, have suggested that the Bank of Japan should begin to purchase foreign bonds as a way to weaken the currency - but that is tricky due to the fact that the Ministry of Finance has authority to instigate intervention in FX markets, not the BoJ. However, SocGen argue there is a grey zone: [T]here are two basic routes imaginable to implement a foreign APP. One, the BoJ Act, which defines the role and functions of the BoJ, could be amended by parliament so as to give the BoJ competency also in the field of FX intervention. Most likely would be that both the BoJ and the MoF would have authority to initiate intervention - it is difficult to imagine that the MoF or any government would want to give up all say in such matters. And, as FX interventions are not without financial risks, it is likely that the BoJ would want some political backing before embarking on such action. Two, and more simply, it is not obvious why the government could not order the BoJ to embark on a strategy of sustained foreign asset purchases, particularly as this would not require any changes in legislation. What are the chances of such a momentous shift in Japan's currency policy? Probably close to zero before the national elections, expected sometime in the next three months. But, given that some opposition politicians have indicated their support for such policy, a change in 2013 is definitely possible. But let's suppose that such a change of tack occurs. What are the outcomes? A very good point made by SocGen is the likely impact on Japanese government bonds: Japan owes its remarkably low government bond yields to the willingness of domestic investors to fund the enormous pile of Japanese public sector debt - they hold some 93% of all outstanding JGBs and T-Bills. The main reason why Japanese investors are thus inclined is the deep-seated perception - based on decades of experience - that any yield pick-up offered by non-Japanese assets tends to be undone by the appreciation of the home currency. If these expectations were to suddenly reverse because the government pursued a policy of currency depreciation, it could trigger flight out of Japanese assets and into foreign ones. This would hurt the economy - by tightening bank funding conditions, raising the cost of domestic credit for the private and public sector - and, it could trigger a crisis in the JGB market. In short, a policy of active yen depreciation could do more harm than good. Although we would add that JGB's are unlikely to be that unloved while the yen is in haven mode anyway. So, from there we get to here: a Swiss style yen-floor. The rationale being that this would keep the exchange rate down and avoid the worst of the asset risk mentioned above. SocGen argue, with some understatement, that: The BoJ in concert with the MoF, could implement a similar policy [to the Swiss]. Of course, many details would need to be worked out. First, the exchange rate itself - what level and against what? There are arguments for a trade-weighted target but for the sake of simplicity it would probably be against the dollar and probably around the Y85 mark, a depreciation from the current level of around Y78. The advantages are clear enough. It would be good for the Japanese export and manufacturing bases, help in the battle against deflation and SocGen argue that by targeting a specific level rather than a continuous devaluation other policy makers would take the move in their strides. From SocGen: Given the drastic appreciation of the yen over the past several years, those policy makers ought to accept that such strategy would be quite reasonable. As any purchases of foreign currencies would find their way into the respective bond markets, there may also be a benefit in terms of low bond yields for those countries. See here for more on the final point. It all makes for a pretty solid argument as it goes but many of the objections we have previously mentioned still exist... in fact, SocGen to their credit make most of them for us including the most important one: The policy we propose would be a bold step, and Japanese policy makers are typically not known for boldness. Hence, the chances that such a policy would be adopted are fairly slim. And there is also the very good chance that SocGen are overestimating how passive other policymakers will be to this. Switzerland is one thing, Japan another. The difference in scale is, well, large even though Switzerland has acted as a stalking horse. As UBS" Chris Walker said: Perhaps you could argue that the international relations aspect is now less relevent in a context of widespread currency debasement (more so than when the SNB took their decision), plus the end of Shirakawa's stint may herald a new era of excessive easing/maybe even bring the BoJ more inline with the MoF. Overall though, I would say the problems with such a policy are still significant And as Valentin Marinov at Citi said, after looking at OTM puts for dollar-yen and euro-swissie for periods over 12 months: [T]hey have essentially the same price. That is, they trade as if there was a peg for USDJPY struck at the previous low below the 76-mark. This could indicate that markets are already working under the assumption we have seen the lows in USDJPY. Although he does say, he thinks it is premature to call for a sustained upside in dollar-yen from here. Either way, you are still looking at a combination of domestic and international political pressure, and the idea that a de facto floor may already exist. Making it explicit would be demanding. But, then again, who saw the Swiss franc floor coming? Related links: The Swiss hill that may become a mountain - FT Alphaville The Swiss boson - FT Alphaville The SNB as victim of a decentralised market structure - FT Alphaville