1 Theory and Practice of International Financial Management Exchange Rate Intervention

2 Exchange Rate Intervention Why do governments attempt to fix exchange rates? Why do governments attempt to fix prices? 1.They think ER volatility is destabilizing - that by removing volatility they will be making people better off. 2.Like any other price fix (i.e. U.S. sugar supports), ER fixes are a political tool. They subsidize one group at the expense of others. 3.To signal intentions.

3 How to Fix Exchange Rates How can a government fix an exchange rate? The same way a government fixes any other price: 1.By controls (much like U.S. price controls in early 1970s). Make trade at a different price illegal. 2.By intervention in the market (much like sugar). By committing to buy/sell at a certain price.

4 1. Exchange Rate Controls Recall our original supply-demand graph for exchange rate determination… Quantity of Pesos $/Peso Demand Supply s

5 1. Exchange Rate Controls If demand for Mexican pesos decreases... Quantity of Pesos $/Peso Demand Supply s

6 s 1. Exchange Rate Controls Quantity of Pesos $/Peso Demand Supply But the Mexican Banco Central makes exchanges of FX illegal at any rate other than s...

7 1. Exchange Rate Controls Quantity of Pesos $/Peso Demand Supply s Dollars will be rationed - there will be excess supply of pesos (demand for $) at the fixed exchange rate of s...

8 1. Exchange Rate Controls Quantity of Pesos $/Peso Demand Supply s A black market will invariably emerge which trades pesos at a discount relative to the fixed rate. sbsb

9 Example: The Uzbek Sum In 1996, the Uzbek central bank fixed the exchange rate at an overvalued level of $0.02 / Sum: Imports were cheap; exports expensive; imports rose by 50% in 1996; exports were down. The central bank started running short of reserves. Daewoo and British American Tobacco experienced delays in converting Sum revenues. Black market exchange rate began falling steadily. In October, the Central bank canceled all conversion licenses and handed out dollar quotas.

10 Example: The Uzbek Sum The government banned the use of dollars inside Uzbekistan. Inflation soared. The black market rate fell to $ / Sum. Foreign investment inflows dried up - decreasing Sum demand further.

11 2. Exchange Rate Intervention Central Bank Balance Sheet (DomesticDA Assets/ Bonds) (Foreign AssetsFACB of Central Bank) C(Currency) R(Reserves of Commercial Banks)

12 2. Exchange Rate Intervention Central Bank Balance Sheet (DomesticDA Assets/ Bonds) (Foreign AssetsFACB of Central Bank) C(Currency) R(Reserves of Commercial Banks) H (High Powered Money) Accounting Identity: DA + FACB = H

13 2. Exchange Rate Intervention To insure that the exchange rate remains at a constant level, the central bank must purchase/sell FX to ensure supply intersects demand at the appropriate price: Quantity of Pesos $/Peso Demand Supply s

14 2. Exchange Rate Intervention Suppose the central bank is trying to target an exchange rate of s. Quantity of DM $/Peso Demand Supply s

15 2. Exchange Rate Intervention What happens if demand for Pesos increases? Quantity of Pesos $/Peso Demand Supply s s

16 2. Exchange Rate Intervention Unless something is done, the exchange rate will appreciate to s. Quantity of Pesos $/Peso Demand Supply s s

17 What should the Central Bank Do? 3 Options: 1.Discourage capital inflows. Curb demand. Example: Chile.

18 Option 1. Discourage Inflows Quantity of Pesos $/Peso Demand Supply s s Enact policies which curb demand for peso (i.e. ‘Tobin Taxes’) and push intersection back to original level.

19 What should the Central Bank Do? 3 Options: 1.Discourage capital inflows. Curb demand. Example: Chile. 2.Print Money: Unsterilized Intervention Supply as many Pesos as the market wants at the fixed exchange rate.

20 Banco Central offers sufficient peso supply in the FX market to meet demand at s Option 2: Unsterilized Intervention Quantity of Pesos $/Peso Demand Supply s s

21 What does this mean for the Central Bank’s balance sheet? They supply Pesos for $. Reserves of $ will increase:  FACB > 0 Since the central bank is selling Pesos, the supply of currency must increase too: Option 2: Unsterilized Intervention

22 What does this mean for the Central Bank’s balance sheet? They supply Pesos for $. Reserves of $ will increase:  FACB > 0 Since the central bank is selling Pesos, the supply of currency must increase too: FACB + DA = H Option 2: Unsterilized Intervention

23 What should the Central Bank Do? 3 Options: 1.Discourage capital inflows. Curb demand. Example: Chile. 2.Print Money: Unsterilized Intervention Supply as many Pesos as the market wants at the fixed exchange rate. Expanded monetary base will result in inflation.

24 What should the Central Bank Do? 3 Options: 1.Discourage capital inflows. Curb demand. Example: Chile. 2.Print Money: Unsterilized Intervention Supply as many Pesos as the market wants at the fixed exchange rate. Expanded monetary base will result in inflation, leading to RER appreciation: e = s P* P

25 What Should the Central Bank Do? 3.Sterilized Intervention: a.Supply currency in FX market to maintain exchange rate:

26 What Should the Central Bank Do? 3.Sterilized Intervention: a.Supply currency in FX market to maintain exchange rate: FACB + DA = H b.Then sell bonds in Money Market to reduce monetary base (‘sterilizing the inflows’):

27 b.Then sell bonds in Money Market to reduce monetary base (‘sterilizing the inflows’): FACB + DA = H 3.Sterilized Intervention: a.Supply currency in FX market to maintain exchange rate: FACB + DA = H What Should the Central Bank Do? Benefits: Less inflationary impact and RER appreciation. Costs: To sell bonds, may need to raise interest rates. Can cause further capital inflows and economic slowdown. May need corresponding fiscal adjustment.

28 Example: Norwegian Krone In late 1996, the Norwegian Krone appreciated by 3.5%: Booming North Sea oil production and rising price of oil had resulted in jump in current account surplus (7.7% of GDP) for the world’s 2nd largest oil exporter. Jump in exports put pressure on Krone to appreciate. To maintain competitiveness of non-oil exporters, central bank wanted to maintain a ‘stable krone.’ Norges Bank intervened heavily in foreign exchange markets, selling 20 billion Kroner in the first week of 1997.

29 Example: Norwegian Krone Although Norway no longer has any long-term state debt, to reduce inflationary pressure, Norway sterilized inflows with short-term borrowing and conservative spending. Tight fiscal policies allowed Norges Bank to actually reduce interest rates. Upon announcing a recent interest rate cut, Finance Minister Jens Stoltenberg said, “We’ve achieved international credibility by maintaining tight fiscal policy, and showing we have no intention of fueling the economy with oil funds.”

30 Relationship to Balance of Payments Remember: Current Account + Capital Account = Changes in Reserves

31 Relationship to Balance of Payments Remember: Current Account + Capital Account = Changes in Reserves If demand for pesos by purchasers of Mexican assets and exports

32 Relationship to Balance of Payments Remember: Current Account + Capital Account = Changes in Reserves If demand for pesos by purchasers of Mexican assets and exports is greater than supply of pesos by importers of U.S. exports and assets >

33 Relationship to Balance of Payments Remember: Current Account + Capital Account = Changes in Reserves If demand for pesos by purchasers of Mexican assets and exports is greater than supply of pesos by importers of U.S. exports and assets > Either prices, returns, and exchange rates will adjust to equate the two or Banco Central’s reserves will grow. +

34 Key Points 1. Influencing an exchange rate is exactly like any other price - a government must be able to alter supply and demand. 2. A government has two options: a. Make trade at other levels illegal. b. Commit to buy or sell at a given price. 3. A government is better off if demand for currency is greater than supply vs. the opposite. Why? Because the government can increase supply limitlessly, but cannot increase demand limitlessly (it can print its own currency but not FX).

35 Key Points 4. If demand is less than supply, the government will only be able to increase demand by using limited reserves of foreign exchange. Unless something changes, it will run out and either must make exchange at other rates illegal or allow adjustment. 5. If demand is greater than supply, and the government does not restrict demand, it has two options: sterilized and unsterilized intervention. 6. With unsterilized intervention, the government simply prints money to meet demand - leading to inflation. 7. With sterilized intervention, the central bank removes the new currency from circulation by selling bonds - creating a decline in high-powered money with a decline in domestic assets - leading to less inflation.