THREE MYTHS OF FX MARKET INTERVENTION

yth 1: JCK intervene because they are mercantilists

Mercantilism originated from the belief under the precious-metal-based monetary regime that deflation, often coupled with economic contraction, would follow fund outflows resulting from a trade deficit, and thus, trade surplus is always better than trade deficit. Even today, with increasing international capital flows and trade integration under fiat money, people in many countries-not only JCK-still tend to favor trade surplus to deficit. However, the primary policy goal of JCK is not to achieve a trade surplus as the classical mercantilism would dictate.

This is particularly true (maybe also confusing) in the case of China. In our view, China should not be labeled as pursuing a mercantilist foreign exchange policy. Granted, the U.S. is running the biggest bilateral trade deficit with China among all our trading partners. However, China's overall trade picture is becoming much more balanced, with its trade surplus shrinking significantly after WTO. In fact, the first four months of 2004 all ended in deficit. Even so, China has made it clear that it intends to "keep RMB exchange rate stable at a reasonable and equilibrium level" in the foreseeable future.

Korea had a long history of trade deficits starting from 1960 and lasting to the mid-1990s. The chief causes are capital and intermediate goods imports in the course of a rapid economic expansion. This was reversed only after the 1997-98 financial crisis. As Korea experienced knee-crunching adjustments to domestic demand, accumulating foreign reserves became a top priority in the near term. However, we don't think mercantilism gives an accurate description of the government's stance.

Japan has suffered languishing consumption and investment for a decade. The latest rebound since the beginning of 2003 is largely attributed to increases in investment and exports. The latter contributed one fourth to the 2.7 percent GDP growth in 2003. Until private consumption catches up and deflation disappears completely, the Japanese government hopes that strong exports will prevent the economy from stalling again.

Myth 2: JCK intervene to smooth out volatility

Many believe that the interventions are meant to smooth out exchange rate volatility for the benefit of reduced risks involved in trade and investment. But if this is the major reason, one simply would not expect JCK's intervention to be as relentless and volatile as observed in reality. Often the intervention seems to work to the contrary of reducing volatility.

In Korea, it is not rare for the government to buy as much as $1 billion in a single day-over a third of the trading volume. The Japanese government in several cases bought more than $10 billion in one day even in the absence of any strong market pressure for the yen to appreciate. Operations in these magnitudes could move the daily exchange rate by as much as 2 percent [Figure 1].

We believe that rather than trying to smooth out volatility of exchange rate movement per se, these interventions focus more on depleting speculators' long positions in local currencies. JCK authorities want to show they are the boss in the hope that speculators "once bitten" by a massive government intervention will become "twice shy" in moving against them. The effort to tame the market is often motivated by not-purely-economic reasons.

Myth 3: JCK are shifting from buying dollars to buying other reserve currencies

Although the exact number is hard to get, it is widely believed that as much as 80 percent of Asian foreign reserves are in dollars. As the U.S. trade deficit hit 5 percent of GDP, many worry that Asian countries would reallocate foreign reserve funds to have less dollar assets and more euro or yen assets, and that the shift can cause further downward pressure on the dollar. Some see this already reflected in the recent appreciation of euro against dollar. However, there is no hard evidence of such a shift.

First of all, JCK's holding of U.S. treasury securities has continued to climb [Figure 2]. Secondly, no decline in their possession of securities of so-called GSEs. Third, although euro assets have gained increasing acceptance, they are not perfect substitutes yet for dollar assets in terms of liquidity and security.

In Japan, one potential problem is that holding increasingly large foreign reserves can be much more costly if interest rates rise quickly following a recovery. In that case, it doesn't matter whether the foreign reserves are in dollar or euro. As Japan gains more confidence in its economy, it may scale down its dollar-buying intervention and purchase of dollar assets. In any event, that doesn't mean Japan will increase the euro proportion in the foreign reserves.

Korea appears to plan on shoring up the return on its dollar holdings instead of altering the denomination of its foreign reserve assets. The government may seek higher- yield, albeit riskier assets. The Korean Investment Corporation was established this year with $20 billion from foreign reserves.

As far as China is concerned, there has been no sign of reshuffle in reserve currencies' holdings.

Conclusion

From a pure economic point of view, JCK's foreign exchange policies may indeed be inefficient and misleading. Nonetheless, by intervening in the foreign exchange market, these countries are acting rationally under their particular circumstances. Each country does try to maximize its utility function, which may include many more political and social factors than people would typically consider in a country like the U.S. Only when the cost exceeds the perceived benefit, will JCK reduce their intervention.