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217 IB IN PRACTICE G7 Foreign Exchange Intervention Currency fluctuations have considerable impact on financial transactions. They are among the factors that determine whether importing or manufacturing locally is more advantageous, for instance. Imagine you are operating with U.S. dollar earnings and you sign a purchase agreement for $100,000, payable in euros when you receive your purchase. At the time of signing, the cost of each euro was US$0.8895. Now, years later (we’re exaggerating for the sake of our example), your purchase arrives but the price of each euro has risen to US$1.50. Your $100,000 purchase will now cost you $161,050 or $61,050 more in U.S. dollars than you anticipated at the time of purchase, a substantial difference. We now look at why these currency fluctuations occur, that is, what forces determine exchange rates. We begin with a brief review of how exchange rates are determined and then move on to the interesting question of what causes them to fluctuate. WHY FOREIGN CURRENCY EXCHANGE OCCURS People often like to do business in their own currency because they don’t like to assume the risk that can accompany currency exchange. Yet that’s not always possible, because of customer needs or market competition. Foreign exchange quotations—the price of one currency expressed in terms of another—are reported in the world’s currency exchange markets in terms of the U.S. dollar, and increasingly the euro and the local currency. Historically, the U.S. dollar has played a central role as a main central reserve asset of many countries, a vehicle currency, and an intervention currency. A vehicle currency is a currency that is used for international trade or investment. For example, the diamond market uses the U.S. dollar as a vehicle currency. An intervention currency is one that is used by central banks to intervene in the foreign currency exchange markets. Often the intervention involves buying up domestic currency to reduce its supply in the market, and thereby strengthen it. As we saw in our discussion of the BIS, 87 percent of currency trades used the dollar as a vehicle currency.14 vehicle currency A currency used as a vehicle for international trade or investment intervention currency A currency used by a country to intervene in the foreign currency exchange markets After a devastating earthquake and tsunami struck the east coast of Honshu, Japan, on March 11, 2011, the yen strengthened considerably. Before the quake, someone wanting to buy yen with dollars could do so at a rate of $1.00 buying ¥82.27. In the first week after the earthquake, however, that dollar would buy only ¥76.25. This change seems illogical at first, because we would expect a country facing a disaster to have a weakening currency, that is, that we could buy more yen per dollar. Japan’s economy was severely damaged by the earthquake, tsunami, and nuclear disaster, so in order to defend against a weakening currency, the Bank of Japan fed yen into the market to make sure they were available, that the market was liquid. This action should have weakened the yen, but instead, the yen’s value against the dollar increased, an unexpected result that, because it was disorderly, threatened the stability of global economic markets. The yen had strengthened on speculation by currency traders that Japanese global businesses would repatriate money to contribute to Japan’s recovery, out of loyalty to their home country. Here’s what happened next. The Bank of Japan, joined by European and North American central banks, all G7 members, intervened in the market and began selling more yen into it. The Financial Times reports that within hours, the yen’s value had reversed course and begun to weaken. It moved quickly to above ¥80 to the dollar and continued to weaken. This coordinated G7 currency intervention was the first in 10 years and was prompted by the disorderly trading pattern in the yen against the dollar, threatening financial stability far beyond Japan, on a global level. Questions 1. With a natural disaster, why would we expect a country’s currency to weaken? 2. Why were the G7 so quick to intervene? Source: Peter Graham, “Action by G7 Marks Turning Point for Yen,” Financial Times, Foreign Exchange Special Report, March 23, 2011, p. 2.


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