Foreign Exchange Intervention

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Table of Contents

Introduction
Public or private intervention
Coordinated and unilateral interventions
Effectiveness of intervention
Conclusion
Works Cited

Introduction

Foreign exchange intervention refers to transactions or announcements by a government agent which is meant to change the value of the exchange rate or the nation’s foreign exchange reserves. A countries monetary authority or officials in the treasury departments or ministry of finance usually carry out these interventions.

For central banks, foreign exchange intervention often involves selling or buying foreign assets against certain state assets in the foreign exchange market. The purchases made are useful in reducing the countries home currency value while sales are intended to increase it. Foreign exchange interventions are carried out so as to correct disorderly conditions in the market (Dominguez & Frankel 55).

The United States employs foreign exchange intervention to reduced sudden changes in the foreign exchange and slow volatility. Often, foreign exchange interventions can change the trends of the exchange rates. Since foreign exchange interventions do not affect other variables such as price, interest rates, it is not possible to be certain about the future trend of the foreign exchange rates. This may present a problem for policy makers as they will be unable to determine the long-term trends (Dominguez & Frankel 55).

There are two types of intervention, i.e. sterilized and non-sterilized intervention. Sterilized intervention can provide a policy tool which can be useful in the resolution of internal and external problems in foreign exchange markets. Sterilized intervention can affect exchange rates in two different ways.

These are the signaling and the portfolio balance channels. The portfolio balance channel can be useful only if the foreign and domestic bonds are imperfect substitutes and also outside assets. Sterilized intervention can also be implemented successfully if a country’s monetary authority has more information about relevant matters than the market and it can pass this information by signaling through foreign exchange rate intervention. (Dominguez & Frankel 58)

According to the Ricardian Equivalence Theorem, government borrowing has no effect on the interest rates. This theory is effective when the public knows and expects that future taxation is what will service the present government debts.

Therefore, the public saves more money as it anticipates the future taxes while the demand of government bonds increases to meet the new supply. Consequently, government debt cannot be viewed as a real outside asset. In this kind of environment sterilized interventions are just changes to the composition of assets in the inside assets thus there is no effect on the foreign exchange market.

Sterilized intervention is ineffective in conditions where the foreign and domestic assets are substituted perfectly. If investors are apathetic concerning the composition of their investments i.e. whether they have domestic or foreign assets, there will be no effect on the interest rates (Dominguez & Frankel 58).

Portfolio-balance models of exchange determination allow investors to diversify their portfolios between domestic and foreign assets considering expected returns and risk. If the intervention carried out by a government results in a rise in the domestic assets in comparison to foreign assets, there will be a higher rate of return on domestic assets that will be expected by the investors.

The high returns that will be needed to convince investors to hold on to domestic assets is what will create a depreciation of the county’s domestic currency (Dominguez & Frankel 58).

The signaling or information channel is very useful during foreign exchange intervention. Using this method, sterilized intervention will influence the exchange rates by providing the market with information it did not possess or incorporate in decision making in the past.

According to Dominguez & Frankel (59), this method may be effective but it is also controversial. It is based on the presence of a difference between information known by a country’s monetary authority and the market participants. For the system to be effective, it is necessary that the monetary authority has special information and be willing to honestly give this information to the market participants by its operations in the market.

Dominguez & Frankel (59) adds that sterilized intervention can be used by monetary bodies to gain credibility for the future policies. An example is if the central bank wants to reduce the money supply in the market in future, it may signal this plans by supporting the domestic currency at the present. The intervention may include buying domestic assets and offsetting this by selling foreign assets.

If the signals sent by the central bank are received well by the market participants, there will be an influence on the exchange rates. For instance, if the signal is about changes in the future monetary policies, the expectations of the market players will change in accordance to this information. Asset-pricing models prescribe that when there is a change in the expectations of the money supply, there is also a change in the expected exchange rate and this alters the current exchange rate.

Public or private intervention

Although the nature of intervention depends on many factors, most of the time the intervention is not made public. Often, foreign exchange transactions are anonymous meaning that there is no obligation for the brokers to identify the participants.

This practice may be common because the effectiveness of an intervention process depends on the investors actually noticing the kind of signals that are being passed by the central bank. Although many traders usually know when the central bank is involved in the market, sometimes they are not able to discern the participation of the central bank.

A report by the United States officials at the Fed stated the channel that is chosen largely depends on the kind of impression that is intended to make. This will dictate whether the central bank will deal directly with banks or just go through agents. If the intervention is to be visible to the maximum number of participants, the central bank will deal with as many banks as is possible. Transparency may be beneficial in ensuring that the foreign exchange initiative is a success (Dominguez & Frankel 60).

There are a number of reasons why the central bank prefers keeping its interventions secret. One of the reasons is that the bank is not sure about the usefulness of an intervention at that particular time. This could be due to the fact that central bank doesn’t want there to be a major effect of the foreign exchange intervention in the market.

In some countries, the choice to carry out an intervention does not originate from the bank. For instance in the United States, the treasury department and the Fed are both vested with the mandate to implement foreign exchange interventions. This means that there are times when the decisions made by the treasury department are not supported by the Fed. Even though the treasury department mandates intervention policies, it is the Federal Reserve Bank which actually implements these policies.

Another reason why interventions may be kept secret is when the monetary and fiscal policies are not in accordance with the intervention policies. Therefore, they may prefer to keep false signals in the dark. Another reason why interventions are kept secret is that central banks from other countries may request the domestic central bank to carry out an intervention to support another currency. (Dominguez & Frankel 58)

Foreign exchange rate intervention is done so as to deal with some problems in the markets. A disorderly market is one whereby the bid-ask spreads are very large and there is a high volatility in the changes in price. It may take place when investors are in support or against a certain currency. The central bank may intervene secretly if it is clear that a certain currency is almost crossing the resistance level. The central bank may carry out a secret intervention when it needs to alter its own foreign exchange portfolios.

The bank usually attempts to maintain a certain level of reserves for some currencies and reduced those of others. In this case, the central bank would not let its activities go public because it does not want the public to think that the intervention was done with the intention of impacting the foreign exchange rates (Hufner 104).

Coordinated and unilateral interventions

Coordinated central bank interventions are carried out simultaneously by several central banks in support of or against a particular currency. This excludes the interventions that an individual central bank would have taken on its own without regard for the activities of other central banks. Because different economies are interconnected, there are incentives for central banks to carry out joint interventions.

For example, a change in the value of the currency in one country may have major effects on businesses in another country. The possibility of having such problems is what leads central banks to cooperate and carry out an intervention as is deemed fit. One countries misfortune may turn out to be another countries stumbling block unless the countries associated cooperate and rectify the foreign exchange rates. (Hufner 102)

The gains that are expected to accrue to an economy will ensure that all central banks which may be affected by a certain currency’s change take part in the intervention. A change in the value of one currency can adversely affect other currencies. Therefore, it is in the central banks best interest to join other central banks.

One of the main advantages of coordinated foreign exchange interventions is that all countries are forced to cooperate so as to achieve the intended exchange rate levels. Multiple signals that are coordinated in the market will ensure that there is increased investor confidence. This is due to the increase of information that the investors require. (Hufner 102)

The impact of a banks signal in the market depends on its reputation and ability to provide hones signals in comparison to other central banks. For instance, a central bank may join a coordinated intervention to reduce the countries money base so as to signal its desire to reduce inflation in the future. If the signal is received in the market and there is a actually a decrease inflation, then the reputation of that bank will be better. Coordinated interventions are likely to have a better effect that unilateral interventions.

Interventions that are carried out in an attempt to change the exchange rate in the opposite direction from the present trend are referred to as leaning against the wind. Most of the interventions that are carried out to rectify a disorderly market are leaning against the wind. Although this is implicit, the central banks are usually trying to change the exchange rate away from its current trend (Hufner 102).

According to Dominguez & Frankel (64) just because an intervention had the effect of leaning against the wind doesn’t mean that that was that initial motivator. For example, if the central bank intervenes so as to support the domestic currency with the intention of signaling future monetary policy, there may be a change in the trend of the domestic currency.

This should not be considered as leaning against the wind. The interventions that lean toward the wind are those which are motivated by the banks decision to support the present exchange rate trend. For instance, if the central bank finds that there is need to increase the value of the currency, it may take the necessary steps to achieve this are followed (Dominguez & Frankel 64).

Effectiveness of intervention

The most effective interventions are those which are supported by the central bank. These interventions have a high success rate in terms of effectiveness and actual change in the exchange rate. In addition, Interventions which are coordinated between the central bank and other banks are more effective. The foreign currencies that are usually exploited in intervention are from the Federal Reserve and the Exchange Stabilization Fund of the Treasury.

They presently have Japanese yen and the euros. Some times, interventions require cooperation with central banks of other countries. However, the most cooperation is with the central bank of the country whose currency is being intervened. In the past, the Federal Reserve and the Treasury were more open about their transactions. Therefore, the Fed had dealt with many banks and dealers to buy and sell currencies in the spot exchange rate market (Dominguez & Frankel 64).

The interventions that are carried out are normally done with the intention of changing the value of the currency. The central bank often engages in transactions on behalf of the customers. This includes foreign exchange sales and purchases. These transactions are referred to as passive as the customers and not the central bank started them. The customers of the central bank include the government, other central banks and foreign governments.

Intervention normally takes place using spot transactions because they are easy to detect and carry out. This is very important when the central bank wants to send a clear message to the market. The United States currency is the most common intervention currency. However, the yen and the deutsche mark are also being used. Central banks change their portfolios by taking part in foreign exchange swaps and agreements for repurchase.

These will not affect the central banks total net foreign assets thus there are few exchange implications for the bank. In the foreign exchange swap, the central bank simply combines the foreign exchange spot sale with commercial banks or other central banks. This will result in a brief reduction of the monetary base. The foreign exchange repurchase agreements include loans for banks or even central banks. This are then collateralized with assets that are in the foreign currency (Rogoff 68).

Before large interventions are carried out, the central banks enter into swap agreements to facilitate the acquisition of other currency during the intervention process. The agreements are normally done in secret and in small amounts so as to avoid changing the expectations in the market.

The worth or the central banks foreign exchange portfolio may alter over time so as to reflect the changes in the interest and foreign exchange rates. These changes in the value of the foreign exchange portfolio are not interventions. However, they can be affected by the capability of the central bank to engage in other interventions in future. (Radaelli 52)

When the central bank of New York purchases foreign exchange, the commercial banks accounts are credited. If it sells foreign exchange, banks’ reserve accounts are debited. To avoid problems with the domestic matters such as monetary policy, the bank usually offset the impact of the interventions on the bank reserves. Sterilized intervention has no effect on the growth of money or other basic macroeconomic determinants of the exchange rates (Humpage & Shenk 12).

Conclusion

The secrecy that the central banks have concerning the foreign exchange intervention is quite puzzling. Although most governments see this as a good method of operating, it may have some faults and negative consequences. According to theory, disclosure of the interventions that are being undertaken may not be the best thing.

If the central bank discloses all its endeavors, it may loose credibility. The United States government has occasionally gone against this practice and exposed its activities. For instance, it has allowed the board of Governors of the Federal Reserve System to make information about its intervention process available (Dominguez & Frankel 71).

Foreign exchange intervention is a very important process as it ensures the stability of the economy. It ensures that international business is carried out in an optimal way. In addition, the macroeconomic environment is regulated. Other macroeconomic variables such as interest rates can also be maintained at an optimal level. The United States has been involved in several interventions. In the year 1985, the United States and other central banks came together to bring down the value of the dollar.

The US has utilized the intervention approach for many years. The purpose of these interventions has been with the motive of stabilizing disorderly markets, to change the trend in exchange rates and to rebalance the foreign exchange reserve holdings. The situation in the foreign exchange markets could be rather disorderly. Foreign exchange interventions have proven to be a very important practice in the macroeconomic environment (Radaelli 54).

Works Cited

Dominguez, K and Frankel, J. Does foreign exchange intervention work? Washington DC: Peterson Institute. 1993. Print.

Hufner, Felix. Foreign exchange intervention as a monetary policy instrument: evidence for inflation targeting countries, Manheim: Springer, 2004. Print.

Radaelli, Giorgio. Exchange rate determination and control. London: Routledge, 2002. Print.

Rogoff, Kenneth. Handbook of international economics. London: Elsevier, 1995. Print.

Shenk, Michael and Humpage Owen. Is Foreign Exchange Intervention a Good Idea? 2007. International Markets. Web.

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