Brad Setser on the US's Unusual Japanese Yen Intervention

In this episode of the Odd Lots podcast, hosts Tracy Alloway and Joe Weisenthal interview Brad Setser, senior fellow at the Council on Foreign Relations, about the recent US Treasury intervention in the Japanese yen market. Treasury Secretary Scott Bessent's to-do list, which included "buy Japanese yen, JPY 5-10 billion," prompted discussion of why such intervention was deemed necessary.

Setser explains the broader context of currency weakness across East Asia. Despite record current account surpluses throughout the region—Korea's expected to reach $300-400 billion, Taiwan's doubling to 25-30% of GDP—currencies have weakened. South Korea experienced this paradox because rising equity markets hitting foreign concentration limits forced selling of Korean stocks, depressing the won despite good economic news. Taiwan's central bank actively engineered currency weakness through regulatory changes. China's currency appears undervalued by current account models. Japan, specifically, has a 5% current account surplus driven by investment income rather than trade, along with approximately $1.2 trillion in reserves and substantial foreign assets held by the Government Pension Fund Investment (GPIF).

The yen's weakness stems partly from the Bank of Japan's reluctance to raise interest rates despite inflation above 1%, its policy rate level. Setser outlines various reasons for this hesitation: the BOJ's desire to solidify inflation expectations after decades of deflation, concerns about banking system funding costs, and potential fiscal impacts. However, at 160 yen per dollar, the yen has reached historically extreme weakness—returning to 1960s levels in inflation-adjusted terms.

Regarding the intervention itself, Setser notes the unusual decision to sell euros rather than dollars, which he attributes to Secretary Bessent's background as a currency trader and desire to signal that this represents a view about the yen specifically, not the dollar's weakness. The intervention also utilized the Foreign and International Monetary Authorities Repo Facility (FIMA repo), a Fed facility established during the 2020 pandemic that allows foreign central banks to repo treasuries for dollars at a premium above market rates. This tool provides flexibility, allowing interventions without immediately selling treasuries into the market.

On the question of whether rate-based valuation models—Big Mac Index, behavioral equilibrium exchange rate models, current account models—still work, Setser argues they consistently show Asian currencies as undervalued, indicating that financial flows have pulled currencies far from fundamental measures.

Addressing Adam Posen's critique that currency intervention alone cannot sustain currency defense (citing the 1992 Bank of England example), Setser argues Japan differs because the BOJ appears likely to raise rates, especially if it does so in September. He contends that if the BOJ raises rates faster than the Federal Reserve going forward, the intervention can succeed. Additionally, Japan's unique position as holder of massive unhedged foreign assets through government institutions means that changing expectations about yen weakness could alter flows significantly without traditional repatriation patterns.

Finally, Setser addresses concerns about Japan's fiscal sustainability. While the 30-year Japanese yield has risen from 0.05% in 2016 to around 4% currently, Japan's primary balance (excluding interest payments) is now effectively flat—a significant improvement from previous years. Japan's primary balance compares favorably to the US, UK, and France. Critically, Japan's government holds massive foreign assets generating income, partially offsetting interest payments. Net debt levels have been falling, and the combination of higher nominal growth, improved primary balance, and government foreign asset holdings means Japan's debt dynamics are not necessarily unsustainable if nominal rates converge with inflation and the primary remains stable.