Japanese authorities, while reluctant to act now, may consider engaging in a rare intervention to stem yen rises against the euro if the moves appear to be driven by speculators and sharp enough to severely hurt business sentiment.
If they were to act, authorities will step directly into the euro-yen market despite its low trading volume and may twin it with dollar-yen intervention to maximize the effect, say sources with direct knowledge of government tactics and market players.
Technically it's possible. People talk about the euro-yen market being too small, but that's not an obstacle, said a policymaker with direct knowledge of the matter. Another source expressed a similar view. Both declined to be named due to the sensitivity of the subject.
While policymakers do not draw any line in the sand, some market players expect the chance of action to rise if the euro falls toward 95 yen and pushes the dollar along the way near its record low of 75.31 yen, or Tokyo's Nikkei average below 8,000. The Nikkei closed at 8,639.68 on Thursday.
The euro's drop to a 11-year low on Monday after S&P cut ratings for nine euro zone nations and finance minister's warnings that he was watching the euro-yen moves closely stirred market speculation that Tokyo might step in and buy euros.
Yet with the euro off its lows trading near 99 yen and the dollar roughly steady around 76.50 yen the threat of imminent action has receded.
Tokyo is also wary of pulling the trigger after Washington criticized last year's solo interventions to curb yen rises against the dollar, and given that the yen's gains against the euro are primarily caused by weakness of the single currency.
The euro's decline is driven by Europe's debt problems and the weakness of its economy. In that sense, it broadly reflects fundamentals, the second source said.
The pair's low trading volume could allow to Tokyo get a bigger bang at a lower cost, but at the risk of increasing rather than reducing volatility. Average daily euro-yen turnover, at $111 billion, is triple the size a decade ago but still only a fifth of dollar-yen trade, according to Bank for International Settlements survey published in 2010.
BUSINESS SENTIMENT KEY
For now market players and those familiar with the government's thinking seem to agree that potential benefits are not big enough to justify the risks.
Osamu Takashima, chief currency strategist at Citibank Japan, said a weak euro does hurt exporters given they have penciled in euro rate at around 105-110 yen. However, the share of Europe-bound shipments was not big enough to have a sizeable economic impact.
I don't think there's much possibility of euro-yen intervention, he said. It isn't a serious matter.
The dollar remains the main settlement currency for most Japanese firms and exports to Europe make up about 10 percent of Japanese exports, compared to more than 50 percent for Asia and nearly 20 percent for the United States.
That view can change, however, if there is evidence -- data or surveys -- that the euro's weakness is causing severe pain to the economy and hurting business confidence, the sources say.
Japan last bought euros in the market in 1999-2003 and during that period bought both the euro and the dollar on 16 out of the 18 days it intervened, with euro quantities much smaller than those for dollars.
If Tokyo were to step in to halt euro falls against the yen, it would probably follow a similar pattern, said Masafumi Yamamoto, chief currency strategist at Barclays Bank in Tokyo and a former central bank official.
We thus expect any euro-yen intervention to be aimed at smoothing and not seeking a reversal of the weak euro trend, similar to recent dollar-yen intervention, Yamamoto said.
That would keep Japan's massive foreign reserves dominated by dollar holdings. Tokyo officials have repeatedly said they saw no reason to diversify away from the U.S. currency.
Japanese and U.S. data suggest that out of Japan's nearly $1.3 trillion in reserves, about $1 trillion are held in U.S. Treasuries and around $150 billion in securities other than U.S. government debt.
While it is not clear how much of this is in euros it is probably safe to say there is enough for Japan to continue buying bonds issued by the euro zone's rescue fund to help Europe battle its debt crisis.
Tokyo, which so far has bought 3.655 billion euros ($4.7 billion)of those bonds, would continue to finance the purchases with liquid euro assets to make them neutral for currency flows.
So if something will spur Japan into action it will be most likely a sharp yen spike against both the euro and the dollar.
Japan won't have much choice but to act if the dollar slips to around 75.50 yen and the euro to around 95 yen, said Koji Fukaya, chief currency analyst at Credit Suisse in Tokyo. ($1 = 0.7802 euros)
(Additional reporting by Rie Ishiguro, Tetsushi Kajimoto, Antoni Slodkowski and Lisa Twaronite; Editing by Tomasz Janowski)