Intervention of Central Bank for Exchange Rate Volatility - Essay Example

Central Bank’s intervention for containing volatility of exchange rate Table of Contents Introduction 3 Different kinds of exchange rate system and their characteristics 3 Fixed exchange rate 4 Floating exchange rate 4 Reasons for Central Banks’ interventions on foreign exchange markets 5 Symmetrical dampening of volatility 5 Prevention of overshooting 5 Supplying liquidity and building foreign reserve 5 Effectiveness of central bank interventions 6 Critical research on impact of intervention policy 7 Significance of policy’s impact 7 Intended and unintended impact 8 Potential waste of resources 9 Conclusion 9 Reference list 11 Bibliography 12 Introduction Economic liberalisation and global integration has increased demand for foreign exchange trading across various countries as more and more countries are getting involved in cross-national trading and foreign investment activities. Globalisation has not only blurred national borders in terms of economic transactions but also has increased capital mobility. However, high capital mobility has resulted in emergence of several risks and issues in the financial market and central bank has played an important role in mitigation and management of these risks in various nations. Furthermore, in a number of nations the central bank is essentially responsible for determination of the foreign exchange rate. The exchange rate volatility took prominent shape since the collapse of the Bretton Wood fixed exchange rate system (Galati and Melick, 2002). Since exchange rate plays an important role in supporting international trade, its volatility is seen as a hindrance. Therefore, central banks often make strong effort for minimising the volatility or it’s after effect on business. However, there are several analyses which suggest that central bank’s intervention tend to increase volatility of foreign exchange market while the bank tends to witness losses while managing the volatility. The paper assesses the impact of the central bank intervention on volatility of exchange rate. Meanwhile, various relevant factors such as types of exchange rate systems, potential scope of resource wastage and intended and unwanted impact of intervention policies have been discussed briefly. Different kinds of exchange rate system and their characteristics The foreign exchange market is the prevalent financial market across the globe. Foreign exchange trading is referred to transacting of one currency in exchange of others. Trading of currencies generally takes place in the form of bank transfers and bank deposit. Except for tourism and physical purchases, physical transfer and exchange of currencies rarely happens. The exchange rate system is an imperative characteristic of foreign exchange market and that of the global economic policy. Based on conventional models, exchange rate system can be classified as fixed exchange rate and floating exchange rate. Fixed exchange rate Fixed exchange rate, which is also known as pegged exchange rate, is referred to the arrangement of price determination where rate of one currency (national currency) with respect to other foreign currencies is kept fixed by means of government intervention. Fixed exchange rate has been considered favourable when two or more countries experience similar nature of economic shock because under such situation, equilibrium real exchange rate witnesses negligible changes. Pegged exchange rate has been favoured by presenting arguments that implies that it acts as a nominal anchor when a country undergoes deflation. Fixed rate is preferred by various financial planners because it supports a committed monetary policy and prevents it from being discretionary and thereby prevent inflationary situation (Caramazza and Aziz, 1998; Stockman, 1999). Floating exchange rate Floating nature of exchange rate is primarily determined by the demand and supply of foreign currencies in the exchange market. Floating exchange rate is devoid of external influences and changes freely with respect to market condition. A floating rate is fluctuating in nature and it is often considered risky for nations with weak currencies. Countries are benefited by floating exchange rate only when the affecting external shocks are relatively different from one another. Flexible exchange rate system offers scope for developing alternative monetary policies for adjustment purpose. It was determined that each of these two systems has significant influence on volatility and they do have some contribution in creating volatility in exchange rate which will be further assessed in the following section (Caramazza and Aziz, 1998; Stockman, 1999). Reasons for Central Banks’ interventions on foreign exchange markets The foreign exchange market is occasionally intervened by a country’s central bank solely for the purpose of achieving certain macroeconomic objectives such as inflation control, financial stability and competitiveness in the international market. Besides these reasons, there are other reasons such as improving liquidity in the market, regulating foreign exchange reserve and maintaining foreign exchange reserve. The reasons are discussed elaborately in the following section: Symmetrical dampening of volatility Most studies reveal that central banks intervene to dampen exchange rate volatility and during early period, this used to be the foremost priority of governing bodies. Policymakers argue that central bank should not intervene in short run volatility for it gets adjusted through automatic risk adjustment and market development. However, intervention in long run can prove often useful. Prevention of overshooting Often government bodies intervene in foreign exchange management as a response to minimize or control excessive movement of foreign exchange, which is also referred as overshooting. Examples in this regard comprises of that from Czech Republic, New Zealand, Mexico and Colombia. Overshooting is often dampened by bank’s effort of purchasing large amount of foreign currency to create a reserve. Supplying liquidity and building foreign reserve Liquidity crisis and financial distress frequency calls for central bank intervention for rescue purpose. There are instances from Brazil and Korea in this regard when the respective central banks intervened to minimize the widening gap between offer and bid thereof. Central banks often take part in the foreign exchange market with the intention of influencing the country’s foreign exchange reserve. Building foreign exchange reserve of hard currencies is important to cushion external economic shocks (Moreno, 2005; Tsen, 2014; Baillie and Osterberg, 1997). Effectiveness of central bank interventions Studies suggest that in last two decades between 1985 and 2004 central banks of various countries such as Germany, Japan and the United States had intervened more than 600 times in various financial markets. It was determined that most central banks frequently interfere in their respective foreign exchange market for ensuring their international competitiveness. Large scale assessment has been conducted regarding role of central bank intervention on returns related to exchange rate. General studies suggest that researchers have not been successful to determine impact of the intervention on conditional mean of exchange rate return on a regular basis. On the other hand, impact was relatively evident in case of spot exchange rate and the same was ascertained to be perverse. When put otherwise, purchase of a currency resulted in depreciation of its self-value. The outcome was observed to be persistent in case of coordinated as well as unilateral interventions (Dominguez and Frankel, 1993; Dominguez, 1998; Cadenillas and Zapatero, 1999). Recent studies in this regard further revealed that central bank interventions can influence the exchange rate in very short run. Additionally, several researchers concluded that government intervention tends to increase volatility of exchange rate. In this regard, it was also determined that the level of intervention is fairly high in emerging economies compared to developed economies. It has been already established that negligible amount of consensus can be observed regarding relationship between central bank intervention and exchange rate volatility. Many authors argued that central bank interventions are relatively ineffective in minimizing volatility because they are either inefficient or are being worked out in the wrong direction (Dominguez, 1998; Cadenillas and Zapatero, 1999). In depth analysis suggest that direction of interventions is very important in this regard. For instance, joint intervention between 1985 and 1995 by Federal Reserve and Bundesbank had unconstructive impact on instability while impact of interference by Bank of Norway was considered effective only if they had been implemented when the exchange rate was around the central parity of currency band instead of the weakest band. Some authors explained that central bank interventions result in increasing volatility of exchange rate because the interventions only focus on balancing the equilibrium instead of coordinating market expectations accordingly (Dominguez, 1998; Cadenillas and Zapatero, 1999). Critical research on impact of intervention policy Significance of policy’s impact Central banks are entrusted to deploy different kinds of intervention policies depending upon a particular situation in the foreign exchange market. In the following section, each of the intervention and its significance has been discussed in a detailed manner. Entrustment intervention is chiefly conducted in foreign markets using funds from various local monetary authorities. This kind of intervention is different from other interventions because in other interventions, the process is carried out by using fund of a particular financing authority in the respective country’s market. Moving on with this notion, there is another term that is frequently used, known as reverse entrustment intervention. In this intervention method, the central bank of a country can interfere in its foreign exchange market on behalf of foreign monetary authorities (Vitale, 1999). Frequently, more number of authorities performs intervention together using their own funds in a collaborative manner. Concerted intervention is also known as coordinated intervention. Examples of concerted intervention are Plaza Agreement (1985) and Louvre Accord (1987) where multilateral intervention were proposed for depreciating the overvalued dollar and bring about equilibrium in the current account. Foreign exchange intervention can be further classified on the basis of its impact on the monetary policy. These kinds of interventions are known as sterilized and non-sterilized intervention. Sterilized intervention has negligible impact on the money supply as gain or loss from foreign exchange transactions are balanced with short term domestic asset trading. Sterilized intervention does not influence exchange rate directly, however, it can have an impact by means of the signalling channel and the portfolio-balance channel (Bonser-Neal, 1996; Tsen, 2014). The other kind of intervention policies include those related to spot, forward and option market. Specifically, central banks enter in spot and forward transactions for influencing market volatility. For instance, large scale forward transactions eventually influences spot rate of foreign currencies. For short term impact, often forward interventions are pursued discreetly. Currency and interest swapping are also pursued by central banks for intervention purposes. Options intervention is practised when a country witness devaluation or depreciation of its currency (Tsen, 2014). Intended and unintended impact Central bank intervention can have positive as well as negative impact on exchange rate volatility. The intervention can reduce volatility on if it is able to resolve uncertainty regarding future monetary policy developed by market participants. Intervention by central bank is also considered to make significant contribution towards minimization of speculative bandwagon. However, researches also point out that coordinated interventions and various macroeconomic proclamations result in fluctuations. Central bank interventions for ensuring equilibrium in foreign exchange market often causes inflow and outflow deviations. Furthermore, information processing and discloser by central banks also result in market volatility. Information flow is distorted regarding central bank interventions and consequently, most market players function on their best guesses resulting to further distortion and market instability. Direct negative impact of intervention is not very well research upon but most studies reveal that volatility is mainly created from incomplete information and speculation regarding impact of intervention (The Chinese University of Hong Kong, 2000; Tsen, 2014). Potential waste of resources According to various studies, government intervention in foreign exchange market result in wastage of scare resources. It was determined that central banks mostly result in earning losses from foreign exchange interventions. Since the banks do not have any personal asset to trade for making investment in the foreign exchange market, the losses result in deficit in bank’s balance sheet. Another insight in this regard is that central banks often acquire large amount of foreign exchange reserves for conducting sterilized interventions which again result in unnecessary blockage of fund or resources (Henning, 1999; Khayum, 2003; Engel, 2010). Conclusion Foreign exchange management has become an essential aspect of international trading and cross border activities. Foreign exchange tradition takes place in an almost virtual and integrated financial market by means of various transactions such as spot, forward, option and swap transactions. There are two methods for determination of rate of currencies across the world, namely, fixed and flexible rate systems. Fixed rate system is practiced by means of central bank intervention. The central bank intervention has proved its competency on several occasions in various countries but it does consist of certain flaws as at times it is significantly responsible for alleviating volatility. The paper examines advantages and crucial drawbacks of central bank intervention with respect to foreign exchange volatility and fluctuations in the market thereof. Reference list Baillie, R. T., and Osterberg, W. P., 1997. Why do central banks intervene? Journal of International Money and Finance, 16(6), pp. 909-919. Bonser-Neal, C., 1996. Does central bank intervention stabilize foreign exchange rates?. Economic Review-Federal Reserve Bank of Kansas City, 81, pp. 43-58. Cadenillas, A., and Zapatero, F., 1999. Optimal central bank intervention in the foreign exchange market. Journal of Economic Theory, 87(1), pp. 218-242. Caramazza, F. and Aziz, J., 1998. Fixed or Flexible? Getting the Exchange Rate Right in the 1990s. [pdf] International Monetary Fund. 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The foreign-exchange costs of central bank intervention: evidence from Sweden. Journal of International Money and Finance, 20(2), pp. 219-247. Sweeney, R. J., 1997. Do central banks lose on foreign-exchange intervention? A review article. Journal of Banking & Finance, 21(11), pp. 1667-1684. Read More