1. EXCHANGE-RATE POLICY & THE CENTRAL BANK Chapter 19

2. Exchange Rates are Volatile

4. Costs of Volatile Exchange Rates Exchange rate volatility increases risk in international finance. Ex. Many developing economy corporates issue securities in US$. An exchange rate devaluation will make this more expensive to repay. Exchange rate volatility increases risk in international trade. Ex. Some multinationals earn profits in foreign currency. A revaluation will reduce the domestic currency value of those profits. Ex. Changes in exchange rates will change the relative competiveness of exports and imports.

5. Exchange Rate: E - # of domestic currency units purchased for 1 US$. An increase in E is a depreciation of domestic currency and a decrease in E is an appreciation. Exchange Rates

6. Interest Parity

7. Saving It is January 1 st, and you have D$1000 to save for 1 year. You can put it into: 1. a domestic currency bank account at an interest rate i. 2. a foreign currency bank account at interest rate i F.

8. Payoff to strategy #2 Strategy two has three parts. 1. Buy foreign exchange at spot rate E t to get {D$1000/E t } F dollars. 2. Put {D$1000/S t } F dollars into F bank account. After 1 year get F$(1+i F )×{D$1000/E t } 3. Convert these funds into F$ at exchange rate prevailing at end of year.

9. Uncovered Interest Parity If, deposit funds then deposit in F$ account. If, deposit funds then deposit in D$ account. Then in equilibrium

10. Interest Rate Parity The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rates would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. Approximately

11. Three Reasons UIRP might not hold 1. Future exchange rates are risky, uncovered interest parity does not account for risk. A. Interest Parity Works for Forward Prices Forward Price for currency delivered at t+1 2. Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons. 3. Currency controls

12. Midterm Exam Tuesday, October 21, 2012, 1:30-1:50, LTG Bring writing materials and calculator. Coverage: Money, Central Banks, Interest Rates, Exchange Rates (through Thursday). Semi-open book: Bring 1 A4 size piece of paper with handwritten notes on both sides.

13. Supply and Demand Model

14. Why do exchange rates change? Relative values of two currency determined by supply and demand by traders of the two currencies. Unlike textbook, we will describe a model of domestic country’s forex market in which US$ is vehicle currency Link Price of US$: E is the price of US$ in terms of DCU.

15. From Interest Parity People trade currencies to engage in foreign trade and international investment. Expected (Investment) Profit: Of Domestic Investors in Foreign Economy Of Foreign Investors in Domestic Economy

16. Supply and Demand in Forex Mkt E* Demand Supply Forex Turnover Excess Supply Excess Demand E

17. Equilibrium in the Forex Market Gap between supply and demand of US$ is the Balance of Payments. Two types of Forex Markets Floating: Forces of supply and demand equilibrate markets. Fixed: Gov’t/Central Bank buys excess foreign currency in market.

18. Difference w/ Textbook Textbook version examines US dollar forex market from US perspectives. We focus on market from more international perspective. Supply of US $ liquidity in local forex market is not exogenous.

19. Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods E Supply Demand E* Supply ' E** Domestic Currency Appreciates ⓪ ①

20. Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods E Supply Demand E* Demand ' E** Domestic Currency Depreciates ⓪ ①

21. Foreign Interest Rates Go Up Relative Demand for F$ Goes Up E Supply Demand E* Supply ' Demand ' E** Domestic Currency Depreciates ⓪ ①

22. Why are exchange rates so volatile Exchange rates are volatile because they are based on expectations. Expectations of future exchange rates determine demand for forex today. Waves of optimism and pessimism of future of currency affects currency today.

23. Expectation of E t+1 Increases E Supply Demand E** Supply ' Demand ' E** Domestic Currency Depreciates 1 2

24. D.C. Interest Rates Go Up Relative Demand for US$ Goes Down E Supply Demand E* Supply ' Demand ' E** Domestic Currency Appreciates ⓪ ①

25. E Supply Demand E* Supply ' Demand ' E** Domestic Currency Depreciates Foreign Currency Purchase, D.C. Interest Rates Go Down. Relative Demand for US$ Goes Up ⓪ ①

26. Model of the Exchange Rate Examine UIRP on a logarithmic scale

27. Monetary Policy Transmission Mechanism A rise in policy interest rates will raise money market rates which will lead to forex appreciation. This will raise price of domestic export goods reducing demand. A cut in policy rates will reduce money market rates leading to forex depreciation improving competitiveness of exports increasing demand. The impact of monetary policy will affect demand through an external channel in a way that parallels the effects through the internal channel.

28. Exchange Rate Passthrough Inflation targeting focuses on price stability in consumer goods. In most small and medium economies, substantial share of imported goods in consumer goods. Exchange rate depreciations make imported goods more expensive and can be inflationary. Raising interest rates in the face of depreciation will stabilize exchange rates and inflation.

29. 29 Price Stability and Exchange Rates Lower interest rates will be associated with weakening currencies on average … but… exchange rate movements are volatile and unpredictable. Even central banks that target price stability intervene in forex markets to stabilize volatile exchange rates. Is this consistent with inflation targeting nominal anchor?

30. T-Accounts: Unsterilized Intervention UnSterilized Foreign Currency Purchase UnSterilized Foreign Currency Sale Central Bank Assets Liabilities +100 Foreign Currency +100 Reserve Accounts Central Bank Assets Liabilities -100 Foreign Currency -100 Reserve Accounts

31. Forex Intervention Unsterilized intervention –Gov’t uses open market operations to purchase (sell) foreign currency. Changes level of bank reserves, domestic liquidity, interest rates. Sterilized interventions – Use domestic funds financed by bill issuance or long-term borrowing to purchase foreign currency. 31

32. Unsterilized Intervention D i IBR Clearing Balances i*i* Central Bank Buys Foreign Reserves & Increases Reserves Increases liquidity in interbank market and pushes down interest rates.. i **

33. Three Situations OK 1. Forex Intervention Aids Price Stability Goal: Large share of consumer goods are imported in Asian emerging markets and exchange rates factor into that price. 2. Forex Intervention Does Not Conflict with Inflation Target: When inflation is within the target range, exchange rate stability may work as an auxiliary goal. 33

34. Swiss Monetary Policy Swiss Inflation Target: 0-2% Peg: 1.2 SwF to 1 Euro. Consistent? 34

35. Monetary Policy & Exchange Rates The central impact of the foreign currency intervention is on domestic interest rates. Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves. Monetary policy that does not shift interest rates will not shift exchange rates.

36. 3. Forex Intervention Conflicts with the Target. If inflation near top of the range, then forex intervention that weakens the currency will be inflationary and violate credibility of inflation target. If inflation near bottom of the range, then forex intervention that strengthens the currency will violate target credibility 36 What do you do if?

37. T-Accounts: Sterilized Intervention Sterilized Foreign Currency Purchase/ Issue non-monetary liabilities Sterilized Foreign Currency Sale/ Open Market Purchase Central Bank Assets Liabilities +100 Foreign Currency +100 Stabilizati on Bonds Central Bank Assets Liabilities -100 Foreign Currency +100 Stabilization Bonds -100 Reserve Accounts +100 Reserve Accounts

38. T-Accounts: Sterilized Intervention Sterilized Foreign Currency Purchase/ Open Market Sale Sterilized Foreign Currency Sale/ Open Market Purchase Central Bank Assets Liabilities +100 Foreign Currency -100 Government Securities +100 Reserve Accounts -100 Reserve Accounts Central Bank Assets Liabilities -100 Foreign Currency +100 Government Securities -100 Reserve Accounts +100 Reserve Accounts

39. Link South Korean authorities are back in the local foreign-exchange market, checking the won’s gains after staying fairly quiet for several months, traders in Seoul say. The Bank of Korea is suspected to have bought dollars near the day’s low of 1,031.40 won and again towards the end of local trading hours, around the 1,040 won level, according to three Seoul-based currency traders. Two traders estimated the central bank may have bought more than $500 million worth of the U.S. currency to slow the Korean won’s gains Thursday. This would be the second day in a row that traders suspect the central bank has intervened to cool the won.

41. Effectiveness of Sterilized Intervention Sterilized Intervention may work by signaling future monetary policy intentions. Sterilized purchase of foreign currency increases relative supply of domestic currency assets & puts downward pressure on exchange rates. In developed financial markets, shift of relative assets would be too small to impact forex rates. Evidence suggests that in some emerging markets, sterilization can have some effect on exchange rates. 41

42. Evidence from Latin American intervention Link Link Regression of appreciation or first difference on forex intervention (share of GDP). 42 Sterilized intervention can slow the rate of exchange rate movements but not overall changes!

43. FIXED EXCHANGE RATE

44. Fixed Exchange Rates Link

45. Fixed Exchange Rate: Weakside Currency Target E Demand Supply Forex Turnover E TGT Gov’t Buys Excess Supply US$

46. Fixed Exchange Rate: Strongside Currency Target E Demand Supply Forex Turnover E TGT Gov’t Buys Excess DCU

47. Exchange Rate: S - # of domestic currency units purchased for 1 US$. An increase in S is a depreciation and a decrease in S is an appreciation. Depreciation Rate Exchange Rate Depreciation

48. Fixed Exchange Rate If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then. If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high. i = i F

50. HONG KONG’S UNIQUE MONETARY INSTITUTIONS “Guide to Hong Kong Monetary and Banking Terms” by HKMA.see http://www.hkma.gov.hkhttp://www.hkma.gov.hk

51. Convertibility Undertaking HK Whenever the price of US dollars goes above 7.85, the central bank will sell US dollars at E = 7.85. No one will ever pay more than 7.85HK$ per US$ Whenever the price of US dollars goes below 7.75, the central bank will buy US$ at E = HK$7.75. No one will ever sell for less than 7.75HK$ per US$. “At the exchange-rate levels defined by the strong-side and weak-side Convertibility Undertakings, 7.75 and 7.85, the HKMA stands ready to exchange any amount of US dollars against Hong Kong dollars with licensed banks maintaining Hong Kong-dollar clearing accounts with the HKMA.” Joseph YamJoseph Yam

52. Balance Sheets of the Exchange Fund

53. Reserves: Clearing Balances The reserve requirement in HK is zero. Banks must only have enough reserves to meet all of their payment obligations. Clearing Account: The accounts maintained with the HKMA for settling inter-bank balances and payments between banks and the HKMA. Aggregate Balances: The sum of balances maintained by banks in clearing accounts at the central bank.

54. HK Interbank Market Automatic Pilot D i HIBOR Clearing Balances i FF i*i* HIBOR Interest Rate Above Fed Funds Banks willing to cash in US$ to get more clearing balances to lend. Under convertibility undertaking, HKMA will make those reserves available. Interest rates drop.

55. HK Interbank Market Automatic Pilot D i HIBOR Clearing Balances i FF i*i* HIBOR Interest Rate Below Fed Funds Banks willing to cash in clearing balances to get more US$. Under convertibility undertaking, HKMA will make those US$ available. Interest rates increase.

56. Supply Curve of Reserves For commercial banks, US$ rate is benchmark in normal times (i.e. when peg has credibility). If HIBOR is greater than Fed Funds rate, sell US$ reserves and buy HK$ reserves. If HIBOR is lower than Fed Funds rate, sell HK$ reserves and buy HK$ reserves. HKMA undertakes to adjust supply of clearing balances so that supply of reserves/clearing balances equals the demand at the HIBOR rate which will be set at the benchmark.

57. D i HIBOR Clearing Balances i FF Increased demand pushes up HIBOR Upward pressure on interest rates attracts US$ to HK and pushes E to strong side of band. Banks convert US$ w/ HKMA and get more reserves until HIBOR and Fed Funds are equalized. Automatic Pilot Demand for HK Reserves Rises D´D´ ΔRΔR

58. D i HIBOR Clearing Balances i FF Decreased demand pushes down HIBOR Downward pressure on interest rates attracts HK$ to US and pushes E to weak side of band. Banks convert HKMA$ w/ HKMA and get more US$ until HIBOR and Fed Funds are equalized. Automatic Pilot Demand for HK Reserves Falls D´D´ ΔRΔR

59. Automatic Pilot: Fed Funds Rate Drops D i HIBOR Clearing Balances i FF US Policy Rates Drop US$ move to HK increasing liquidity Under convertibility undertaking, HKMA increases reserves Interest rates decrease. i FF´

60. Automatic Pilot: Fed Funds Rate Rises D i HIBOR Clearing Balances i FF US Policy Rates Rise Banks cash in HK$ to get more US$ to lend. Under convertibility undertaking, HKMA will drain reserves. Interest rates fall. i FF´

61. Loss of Credibility A fixed exchange rate will lose credibility if people come to believe that the central bank will: devalue the currency, (ie. raise S in the future) revalue the currency (ie. reduce S in the future) If market expects an exchange rate change, commercial banks will adjust comparison rate for the expectations of devaluation.

62. Market Expects Revaluation, η < 0 D i HIBOR Clearing Balances i FF Willingness to Hold HK$ Rises US$ move to HK increasing liquidity Under convertibility undertaking, HKMA increases reserves Interest rates decrease. i FF +η ´

63. HK Interbank Market and Expectations of Revaluation

64. Market Expects Revaluation η < 0 S D i IBR i FF S´S´ 1 2 ΔRΔR i FF +η Clearing Balances

65. Market Expects Devaluation η > 0 S D i HIBOR Clearing Balances i FF S´S´ 1 2 ΔRΔR i FF +η

66. Currency Hong Kong’s central bank does not print money. Bank of China, HSBC, and Standard Chartered print banknotes but… the banks can only issue paper notes if they buy licenses from the central bank with US$ at a rate of $1 per HK$7.8 printed. The Licenses are called Certificates of Indebtedness Certificates issued by the Financial Secretary to be held by note-issuing banks as cover for the banknotes they issue. CI’s appear as liabilities on HKMA balance sheet.

67. Certificates of Indebtedness increase when currency increases

68. Coins Coins (and recent 10 Banknotes) are issued by the central bank unlike the USA where they are issued by the Treasury. Definitions here are from the “Guide to Hong Kong Monetary and Banking Terms” by HKMA.see http://www.hkma.gov.hkhttp://www.hkma.gov.hk

69. Reserves: Exchange Fund Bills Exchange Fund Bills and Notes Debt Instruments issued by the HKMA for the account of the Exchange Fund. Since 1990, the Exchange Fund has sold short-term bonds (stretching the maturity structure as time goes on ). Exchange Fund bonds are listed on HKEX and traded in secondary markets.

70. Should government debt be part of the monetary base? Exchange Fund Paper can be held by anyone, but large share is owned by local banks. Therefore, they can be thought of as being mostly secondary reserves of banks. ExFund paper is held primarily for HK$ liquidity management purposes. These instruments are fully backed by Foreign Reserves. The HKMA has undertaken that new Exchange Fund paper will only be issued when there is an inflow of funds.

71. Hong Kong Exchange Fund Bills &Notes: August 2009

72. HKMA & Fed: Similarities & Differences AssetsBase SameCentral Bank Liabilities DifferentFed assets are primarily Treasury securities HKMA assets are primarily foreign currency securities HK liabilities include interest paying tradable securities primarily held by banks Fed Liabilities don’t pay interest. Ex Fund bonds do.

73. HKMA & Fed Similarities & Differences (Monetary Base) CurrencyReserve Accounts Same Large part of monetary base. Banks keep funds at central bank Different Fed prints US currency 3 private banks purchase licenses to print currency. US Reserve accounts are required by regulation. HK Clearing balances are only necessary for transactions.

74. MANAGED FLOAT

75. Managed Floating Most developed/OECD central banks set domestic interest rates in response to domestic price levels. Many emerging markets or developing economies either set a fixed exchange rate or simply use the currency of another country – “Dollarization” Many other emerging markets also practice “managed floating” which sometimes adjusts the interest rate in response to domestic conditions and sometimes intervenes in foreign currency markets to stabilize the price level.

76. Managed Floats

77. Singapore BBC Anchor BBC: Basket, Band, Crawl Basket: Singapore anchors currency to a weighted average of different currency to immunize from changes among large economies. Band: Weighted average allowed to float within a fairly large range of the target. Crawl: Average is scheduled to adjust in a path over time. Weights in the basket, size of the band, rate of crawl are all secrets. Interventions occur in both forex markets and money markets to stabilze interbank rates. Long-term goal is price stability.

78. In October 2013, MAS maintained the modest and gradual appreciation path of the S$NEER policy band, with no change to its slope, width, and the level at which it was centred. This policy stance, which has been in place since April 2012, was assessed to be appropriate, taking into account the balance of risks between external demand uncertainties and rising domestic inflationary pressures. Link

79. Foreign Currency Intervention Managed Floating: Purchase Foreign Central Bank cuts interest rate Domestic Forex rate strengthens Domestic Central Bank purchases forex directly increasing demand for forex. Forex Purchase also expands domestic money supply and reduces domestic interest rates. This helps to keep domestic forex rate from strengthening.

80. Foreign Currency Intervention Managed Floating: Sale Foreign Central Bank raises interest rate Domestic Forex rate weakens Domestic Central Bank sells forex directly increasing supply of forex. Forex Purchase also reduces domestic money supply and increases domestic interest rates. This helps to keep domestic forex rate from weakening.

81. Foreign Currency Sale, D.C. Interest Rates Go Up Relative Demand for US$ Goes Down E Supply Demand E* Supply ' Demand ' 1 E** 2 Domestic Currency Appreciates

82. Capital Controls China among other developing economies operates system of foreign exchange controls. To obtain foreign exchange, Chinese residents must acquire permission from State Administration of Foreign Exchange. Possible for ex/im firms to obtain foreign currency but limit of US$20,000 for individuals investing overseas though banks and mutual funds can apply for a quota of foreign currency.

83. Capital Controls & Interest Rates China’s financial markets remain heavily regulated and are dominated by banks which are owned by central or provincial governments. Central bank is able to set the base lending rate and deposit rate of banks as an instrument of monetary. Since depositors cannot invest overseas, domestic interest rates do not affect demand for US dollars in China’s forex market.

84. Current Account IMF Data Mapper

86. State Administration of Foreign Exchange (SAFE) Large demand for RMB for investment and international trade but demand for dollars limited in China forex market due to capital controls. SAFE sells RMB and acquires US dollar assets. In turn, SAFE sells domestic currency “sterilization” bonds and large reserve requirements to Chinese banks to soak up the money supply.

87. Link