Best left alone

Yen: Japan’s currency has come back down to earth, but not without a longer-term cost. The yen's spike to a record high against the dollar was probably due to speculators betting on the market’s response to last week's earthquake. Still, intervention sends a strong - and possibly wrong - message.

The G7’s main purpose in helping Japan reverse the yen’s surge was to reduce volatility. That is noble enough. Though many exporters hedge their exposure to foreign exchange prices, the cost of doing so rises as the yen lurches around. The volatility implied in one-month yen-dollar options spiked to a two-year high on March 17, and came down after the G7 took group action.

But intervention also plays to the belief that the yen is too strong. Many, not just in Japan, think a rate of fewer than ¥80 to the dollar is too expensive. Back in October 2010 the Peterson Institute, seen as an authority on such matters, called the yen 9 per cent overvalued.

Yet on a trade-weighted basis, and adjusted for inflation, the pre-quake yen was merely back at 2008 levels, according to JPMorgan data. Besides, currency valuation measures are always subjective. Upward pressure can say as much about structural wrinkles as market mispricing. Japan's current account surplus, likely to hit 4 per cent of GDP in 2011, is a powerful force in the direction of a more expensive yen.

Meanwhile, the currency’s effect on exporters may be overstated. Even as the yen has strengthened, corporate bankruptcies in Japan have been declining. And while Japanese manufacturers have spare capacity when compared to average levels since the mid-1970s, this may simply be a sign that exporters expect the yen to come down, so are delaying necessary cuts.

Even if the G7 intervention is short-lived, it is not cost-free. The biggest worry is that it will encourage others to do the same. China is a serial offender when it comes to competitive currency devaluation, and it too claims its real motive is to prevent volatility. The G7 can legitimately argue that it has softened the impact of a calamitous event. But it may have also provided an excuse for future currency wars.