Intervention of central banks in exchange rate markets

Explain how central banks intervene in the exchange rate markets and critically comment on the Bank of England’s view about the impact of the “past depreciation of the sterling” on the UK economy [1] .

Central bank intervenes in the exchange rate markets:

To change the relationship between supply and demand by exchanging between domestic currency and foreign currency

Interventions can be classified into different types: direct intervention and indirect intervention; sterilized intervention and unsterilized intervention; unilateral intervention and joint intervention etc.

Central Bank Intervention:

“The buying or selling of currency, foreign or domestic, by central banks in order to influence market conditions or exchange rate movements.”

Basically in a free floating exchange rate system, the market supply and demand forces solely determined the rate. Central Bank is using these intervention methods due to many reasons behind this defined scenario. Central Bank often using outside sources to take part in these sort of market manipulation also there are specific periods in which central bank intervenes to raise or lower the exchange rate in the floating market. The central banks are often influenced by outside sources to take part in this type of market manipulation. To adopt this intervention scenario Central Bank main objective is to stabilize exchange rate fluctuations. Because, if exchange rate continuously will change then it will automatically create hurdle in global/international trading and investment decisions in business. Because if traders will not confident against the stability of the exchange rate they will automatically reduce their investment actions due to these uncertain conditions and because of this reason investors normally put pressure on Central bank or Government to intervene if the exchange rate continuously fluctuating too much.Another reason for the central bank’s intervention is as an attempt to stop or reverse a country’s trade deficit. This is because a higher exchange rate will make that countries goods and services cheaper. This will motivate imports while oppressive exports, creating a trade deficit. If the deficit is significant enough the central bank may be convinced to intervene to try to reduce the value of the currency by discarding excessive amounts of it on the market.

Therefore intervention usually occurs when countries’ currency is experiencing excessive downward and upward pressure from market players normally entrepreneurs. A momentous decline in the value of a currency has the following negative aspects:

Firstly Due to decline in values of money a state which is facing this large current account deficit means buys more goods and services than it sells from abroad that is dependent upon foreign inflows of capital may undergo a hazardous hold back in the financing of its deficit, which will require increasing interest rates in the market to maintain the value of the currency and, could risk serious ramification on growth.

Secondly It increases the price of imported goods and services and ultimately causes inflation and automatically it will push the central bank to increase interest rates, which will probably harm asset markets and ultimately on economic growth, and it can also lead to additional losses in the currency.

Thirdly it also pushes up the exchange rate of the country’s trading associates and drive up the price of their exports in the international market place. This will also activate serious economic slowdown, especially for those countries which are mainly dependent on export.

On the other hand central banks also intervene to curtail excessive appreciation of their currency, which give more focused on the balance of payments and makes exports less attractive.

Today Foreign exchange interventions have now obtained numerous forms and shapes. Some of them are discussed below;

Intervention occurs when representatives from the Ministry of Finance, central bank or other traders talk up or talk down a currency. This is either done by threatening to commit real intervention (actual buying/selling of currency), or simply by indicating that the currency is undervalued or overvalued. This is the cheapest and simplest form of intervention because it does not involve the use of foreign currency reserves. Nonetheless, its simplicity doesn’t always imply effectiveness. A nation whose central bank is known to intervene more frequently and effectively than other nations is usually more effective in verbal intervention.

Operational Intervention: Generally on behalf of Ministry of Finance or Treasury this is the actual buying or selling of a currency by a country’s central bank.

Concerted Intervention: It occurs when different nations coordinate in raising/driving up or down any currency using their own foreign currency reserves. Its success is dependent upon its extent (number of countries involved) and intensity (total amount of the intervention). Concerted intervention could also be verbal when administrators from several nations unite in expressing their concern over a continuously falling/rising currency.

Sterilized Intervention: When a central bank fumigates its interventions, it compensates these actions through its monetary policy practices (open market operations or interest rate targets adjustments). Selling a currency can be sterilized when the central bank sells money market instruments (short term securities) to drain back the excess funds in circulation as a result of the intervention.

FX interventions only go unsterilized (or partially sterilized) when action in the currency market is in line with monetary and foreign exchange policies, i.e. when the case for intervention is urgent. This occurred in the concerted interventions of the “Plaza Accord” in September 1985 when G7 collaborated to stem the excessive rise of the dollar by buying their currencies and selling the greenback. The action eventually proved to be successful because it was accompanied by supporting monetary policies. Japan raised its short-term interest rates by 200 bps after that weekend, and the 3-month euro rate soared to 8.25%, making Japanese deposits more attractive than their US counterpart. Another example of unsterilized intervention was in February 1987 at the “Louvre Accord” when the G7 joined forces to stop the plunge of the dollar. On that occasion, the Federal Reserve engaged in a series of monetary tightening, pushing up rates by 300 bps to as high as 9.25% in September.

Mostly Use Approaches of Intervention:

There are two intervention approaches the central bank may take. The direct method involves intervention by buying or selling currency in an attempt to manipulate the market. Whereas indirect approaches, attempt to make changes the domestic money supply.

Direct Method:

The direct method is a more obvious method of intervention. The central bank can reduce the value of a currency by flooding the market with it. A raise in the supply of a specific currency will lead to its depreciation n value. Conversely, the central bank can raise the value of a currency by purchasing large amounts of it. The increased demand of the currency will cause it to appreciate.

The long-term effect of this direct intervention is limited. Eventually the market will stabilize and resume its previous trends.

Indirect Method:

The indirect method of intervention attempts to change the exchange rate through changes in the money supply. By increasing the supply of money the value for that currency will decrease. Similarly if the money supply is decreased the value for it will increase. This approach is effective but often takes several weeks to have an impact. This is because it must traverse all market operations before affecting the exchange rate. Another disadvantage of this method is that it also requires the central bank to alter the domestic interest rate to compensate for the change in money supply.

Intervention in the foreign exchange market is done sparingly because of the long-term effects it may have on other domestic factors. For example, changing the money supply will affect interest rates and price levels. This will contribute to a higher inflation rate, higher unemployment rates, and less gross domestic product growth in the long run.

To avoid these long-term effects, a sterilized intervention may be used. Sterilized intervention is intended to change the exchange rate without changing the money supply or interest rates. This type of intervention happens when the central bank offsets its direct intervention by making a simultaneous change in the domestic bond market. Studies have shown that a sterilized intervention of the foreign exchange market will yield short-term temporary results but ultimately have no lasting effects on the county’s currency value. A more lasting effect can be possible if the intervention leads to investors changing their future expectations in the market.

Intervention Impact on Current Market:

Before listing the determinants of a successful FX intervention, it is important to define “success”. Thus, a central bank that spends about $5 billion (medium-size) on intervention and manages to raise/lift the value of its currency by about 2% against the major currencies over the next 30 minutes is said to be successful. Even if the currency ends up losing its gains over the next two trading sessions, the proven ability of that central bank to move the market in the first place gives it some kind of respect for the next time it “threatens” to step in.

Size Matters: The magnitude of the intervention is usually proportional to the resulting move of the currency. Central banks equipped with substantial foreign currency reserves (usually denominated in dollars outside the US), are those that command the most respect in FX interventions.

Timing: Successful FX interventions depend on timing. The more surprising the intervention, the more likely it is that market players are caught off-guard by a large inflow of orders. In contrast, when intervention is largely anticipated, the shock is better absorbed and the impact is less.

Momentum: In order for the “timing” element to work best, intervention is more ideally implemented when the currency is already moving in the intended direction of the intervention. The large volume of the FX market ($1.2 trillion per day) dwarfs any intervention order of $3-5 billion. So central banks usually try to avoid intervening against the market trend, preferring to wait for more favourable currents. This may be done through verbal posturing (jawboning), which sets the general tone for a more fruitful action when the actual intervention begins.

Sterilization. Central banks engaging in monetary policy measures in line with their FX actions (unsterilized intervention) are more likely to trigger a more favourable and lasting change in the currency.

Broadly speaking, there are 03 main channels through which central bank intervene:

01- Portfolio channel:

To bring the large swings in the exchange rates, changes in the desired allocation of currencies in the investor’s portfolio are made. Central bank can reduce the fluctuations to desired level by providing necessary supply of currency.

02- Signaling Channel:

An intervention provides signals about the future course of monetary policy, which in turn affects asset prices. For example, when intervention is undertaken to avoid depreciation, the next step would be to tighten monetary policy, which should strengthen the domestic currency.

03- Information channel:

Authorities transmit certain information to the market via an intervention and its announcements. More uncertain the market gets by information, the more fluctuation results in exchange rates.

Bank of England’s view about the impact of the “past depreciation of the sterling” on the UK economy

The Bank of England expects that the “past depreciation of the sterling” could lead to higher prices and inflation may range between 4% and 5%, while remaining well above 2.0 percent in the upcoming two years.,

As for growth, the bank previously estimated growth to have fallen 0.50 percent during the fourth-quarter of 2010, according to the preliminary GDP report, due to heavy snow, output is broadly flat, but growth in 2011 first quarter is likely to receive a boost on rebounding activities.

Question No 02: Use theory and empirical evidence to evaluate what explains the swings in the current account balance over time.

The current account balance is the sum of four separate balances

The balance of trade in goods

The balance of trade in services

Net investment income from overseas assets

Net transfers of money between people and between governments

A current account surplus increases a country’s net foreign assets by the corresponding amount, and a current account deficit does the reverse. The net balance of trade in goods and services are by far the biggest factor in determining the current account. If there is a deficit on the current account, there will be a surplus on the current account or financials to compensate for the net withdrawals.

Methods to reduce Current Account Deficit:

01- Increasing exports or decreasing imports:

It can be done through import restrictions, quotas, or duties

Influencing the exchange rate to make exports cheaper for foreign buyers

02- Promoting investor friendly environment

It can be done through Foreign direct investments

To favor domestic suppliers

Current Account Deficit:

Current Account Deficit occurs when a nation’s total imports of goods, services and transfers are greater than the nations’ total export of goods, services and transfers. This situation makes a country a net debtor for the rest of the world. But many developing counties may do a current account deficit for shorter time to increase local productivity and exports in the future.

Few countries like the UK may become an attractive destination for long term investment in other words Capital inflows and this makes a current account deficit easier to finance. Therefore it may depend on the size of the country and also the people which having confidence in investing their investments as global trade. For example a developing economy may find it more difficult to attract capital flows but developed economy can easily take participation in this sort f trading in rate is stable not much fluctuating.

What does a current account deficit tell us about the performance of an economy?

A current account deficit is not necessarily or automatically a bad thing!

The UK has run a deficit since 1998 but its overall macroeconomic achievements have been good

Germany has run a sizeable and growing surplus in recent years but has suffered from slow growth and high unemployment

Japan has enormous current account surpluses but has had three recessions in the last twelve years

Much depends on

The causes of a current account deficit

Whether or not the deficit is likely to correct itself as an economy moves through a normal cycle

Whether or not the deficit can be easily financed through attracting sufficient capital inflows

Question 03: Analyse the UK’s balance of payments for a period of 10 years (data given in Tables 1 and 2). The analysis should include examinations (presentations of statistical data with discussion based on theory, journal articles, and examples from the market) of the current account balance and capital/financial account balance. Document the trends and investigate the causes.

Analyses of UK balance of payment reveals following:

Surplus on trade in services over period of time starting from 23 (Billion $) in 1997 to 74 (billion $) in 2009

Increase in deficit on trade in goods over a period of time starting from 20 (Billion $) in 1997 to 128 (Billion $) in 2009

Exports of goods and services started with positive balance in 1997, however, afterwards deficit was reported over a period of time and reached to 94 billion deficit in 2007 and then 89 billion in 2008, whilst in 2009 deficit reduced to the extent of 55 billion

Taken as a whole, the current account deficit was over 37 billion

What does the current account deficit tell us about the UK?

Consumption: Partly the deficit is the result of a period of sustained economic growth and strong consumer demand for goods and services – our manufacturing sector is not large enough to meet all of the demand for consumer goods and durables, so we must import to satisfy this excess demand

UK consumers have a high marginal propensity to import as income rises

Many imported manufacturing goods are relatively cheaper than UK substitutes – this causes a substitution effect towards overseas output

The long run decline of manufacturing limits the choice of domestic supplier for us to choose

Strength : The trade deficit in goods has been affected by the strength of the UK exchange rate e.g. the appreciation in the value of pound

Services: Trade surplus in services is improving, it reflects comparative advantage in many service industries

Investment Income: This is quite volatile from year to year – but uk surplus reflects a large amount of overseas investment by UK businesses over recent years (including investing in new plant, retail outlets and acquisitions of foreign owned businesses). This helps to stabilize balance of payments, without it the current account deficit would be much more of a problem

Day to day the current account deficit is not a major problem for the UK owing to following reasons:

It is now easier to finance a current account deficit because of globalization and international financial market liberalization. Even if a country is running a current account surplus, provided there is a capital account surplus, there is no fundamental economic constraint.

The UK has found it fairly easy to attract these capital flows

Why?

Interest rates: Short term interest rates are higher than in for example the Euro Zone and the United States. This attracts inflows of money into our banking system seeking a favorable rate of interest

FDI: Britain’s economy remains a favored venue for inflows of foreign direct investment – supply side reasons including a more flexible labor market and low cost and wage inflation help explain this

Investment in markets: Foreign investors are keen to buy into competitive UK product markets including communication industries, transport, and financial services

The current account deficit is not a fundamental problem for Britain – not when it is only 2 – 2.5% of our GDP.

And

Slower growth: At some point the British economy will experience a phase of slower growth and weaker consumer spending – this will dampen down the demand for imported goods and services. For example there is already widespread evidence of a slowdown in the housing market following the recent series of small increases in official interest rates by the Bank of England

A lower pound: The exchange rate may start to depreciate in the coming years providing a boost those UK industries exposed to competition in international markets

But there are grounds for worrying about the current account deficit

The deficit reflects an unbalanced economy with consumers spending beyond their means

The deficit reflects a loss of cost and price competitiveness in export sectors some of which is the result of a poor supply side performance in terms of low productivity, insufficient research and development and a lack of innovation and other forms of non-price competitiveness

A rising current account deficit may lead to increasing import penetration in domestic markets, which threatens jobs and living standards in the medium term

There is no guarantee that the free flow of capital into a country will continue this will then create a “financing problem” for the UK. It is a bit like the bank deciding to stop lending you money when you keep going back to them to ask them to give you another extension to your overdraft or loan!