Central Bank Interventions and Foreign Exchange Rate Volatility - Essay Example

Central Bank Interventions and Foreign Exchange Rate Volatility Contents Contents 2 Introduction 3 Literature Review 3 Discussion 4 Exchange Rate Regimes 4 Causes of Volatility 7 Reasons for Central Banks Interventions on Foreign Exchange Markets 8 Effectiveness of Central Bank interventions 9 The Hedging Decision of Beazley Development Plc 11 Conclusion 12 Bibliography 15 Introduction Central bank intervention may be defined as the situation when central bank of an economy enters the foreign exchange market to buy and sell currencies for the purpose of controlling the exchange rate volatility. As the government of all economy always strives to stabilize the financial market condition of the economy, central bank intervention is important to eliminate spill over effects on financial markets and make monetary policy framework more effective (Beine, Laurent and Lecourt, 2001). However, there is no agreement among the scholars regarding the effectiveness of such activities done by central bank in order to control foreign exchange market. Some researchers are on the opinion that such intervention policies are ineffective and may lead to increase the degree of foreign exchange volatility whereas other academic intellectuals sighted that central bank volatility can become the potential reason behind reducing exchange rate volatility. Another consensus views central bank intervention as ineffective and a waste of taxpayers’ money. In this paper the effect of central bank intervention, exchange rate regimes and currency risk hedging decisions will be analysed in order to evaluate whether the central bank intervention impacts positively on the level of volatility of foreign exchange rate or not. Literature Review Central bank intervention has always been a controversial policy among all researchers across world. According to a report from Wall Street Journal, central bank intervention is not only futile to manage exchange rate but also perilous as it may increase volatility of exchange rate. However, it is also evident that in some cases such intervention has a positive or limited effect of such volatility as well (Suranovic, 2004). During the period of Bretton Woods Exchange Rate System, central bank intervention had become necessary each time the exchange rates surpasses their parity bands. In 1973, after the dissolution of this exchange rate system, the intervention policy became country specific. In 1977, International Monetary Fund (IMF) formulated three distinct guidelines for its member countries to bring uniformity in the intervention practices. First, countries were not authorized to manipulate exchange rate for adjusting their Balance of Payment (BOP) or for gaining any discriminatory competitive advantages. Secondly, countries were legitimated to intervene only for countering the disorderly market conditions and finally, countries were directed to always take into account the exchange rate interests of other countries as well. Under such policy framework, dollar appreciated by 40% against mark (currency of Germany) and US trade deficit lowered to $100 billion (Inoue, 2012). The G5 countries (Brazil, South Africa, China, Mexico and India) continued to intervene on various occasions till 1990. Statistics showed that intervention operations of Federal Bank resulted in average daily volume of foreign exchange trading over a million of dollars (Beinea, Quéré, Dauchyc and MacDonald, 2003). In order to evaluate whether intervention operations influence volatility of exchange rate, characteristics of different exchange rate system must be analysed. Discussion Exchange Rate Regimes Exchange rate indicates the rate at which home currency can be exchanged for a foreign currency. It also signifies the value of one currency with respect to other currencies. Exchange rate regime shows how a government can manage its currency in relation to other currencies in the foreign exchange market (Ghosh, Wolf and Wolf, 2002). The two main exchange rates are: The Floating Exchange Rate Floating exchange rate is the exchange rate regime in which the value of the currency is allowed to fluctuate as per the condition of foreign exchange markets. Dollar is a perfect example of floating currency that is used in this type of exchange rate system. Experts have identified the floating exchange rate to be the best possible system in exchange rate regime because of its ability to adjust automatically in various economic circumstances and safeguard a country from the negative impacts of demand and supply shock as well as oversee business cycle. These self correcting exchange rate regimes lead to boost up economy by stimulating the demand for local goods and services. The Fixed Exchange Rate In this exchange rate regime the governments decide the worth of their home currency in relation to a fixed weight of a specific asset or a basket of a standard foreign currency and the central bank of the country tends to commit for buying and selling of its currency as against the standard currency at a stipulated price. A pegged currency with narrow bands as lower as less than 1% falls under fixed exchange rate regime. In order to ensure that the currency of one currency will remain pegged, the central bank of the country tends to maintain a sound level of gold and foreign exchange reserve. Central bank intervention in foreign exchange market is done by buying or selling the reserves to control excess demand or excess supply of the currency of home country. Gold is the widely accepted standard for a currency to be pegged under fixed exchange rate system. Apart from this, a strong currency of a particular nation can also be pegged as single currency or a basket of currencies with the major trading partners of the country. Implications of Fixed and Floating Exchange Rate System on Exchange Rate Volatility Volatility indicates the degree of change in a variable over a certain period of time. The larger or faster is the magnitude of the change in variable, it is said to be more volatile. Volatility in exchange rate complicates the trade and investment decisions in the international framework as exchange volatility increases the scale of business risk. Such exchange rate risk signifies the potential loss of money for both trader and investors. As the fixed exchange rate system does not involve any fluctuations except devaluation or revaluation, the volatility factor is less in this regime. A floating exchange rate is expected to be more volatile as this exchange regime is free to change while required. However, the degree of volatility largely depends on the frequency of global economic and financial occurrences that may influence the change under floating exchange regime (Miyajima, 2013). In the period of 1990s, the international financial crisis that had affected Asia, Latin America and Russia in a massive way compelled the policy makers to rethink of a proper exchange rate regime that may solve the purpose of both rich as well as poor countries. As a result, most of the economists have come out with an opinion to establish a fixed-but adjustable exchange rate regime. In general, the fixed exchange rate system supports economic stability whereas the floating exchange rate enhances the scope for absorbing external terms of trade shocks. Taking into consideration the indicators of GDP growth such as education, government spending, per capita income, economic openness etc it is evident that the economies with flexible exchange rate regime tends to grow more rapidly as compared to economies with fixed exchange rates. Concentrating on external trade shocks, it has been experienced that the economic growth is exacerbated in countries with a rigid exchange rate system. In contrast, under flexible rate regime the effect of trade shocks on economic growth is approximately half than that of under pegged system. Researchers have also shown that the growth of aggregate output is more sensitive to negative shocks and such sensitivity factors increases when the inflexibility of the exchange rate regime amplifies. Therefore, the advantage of floating exchange rate system can be attributed as the ability of this exchange rate regime to adjust with the negative shocks the real exchange rate. In a pegged exchange rate regime, as the depreciation of real exchange rate indicates decrease in nominal prices, the negative trade shocks may in turn lead to create massive unemployment and decelerate economic growth if the nominal price is too stiff. Hence, apparently the floating exchange rate regime tends to create volatility in the market. However, extensive research indicates that such exchange rate regime leads to reduce economic volatility. Causes of Volatility The exchange rate volatility arises mainly out of three factors. These can be attributed as: Fundamental Market Volatility As the money exchange rate is the function of the fundamentals of market such as money supply, interest rate and income, a change in at least one of these factors lead to change the level of exchange rate; thus initiating a exchange rate volatility. Degree of Confidence Alteration in market confidence such as a prediction on future economic or financial conditions tends to raise uncertainty in the market. Such information may boost or hamper the confidence of the market and accordingly leads to volatility in the exchange rate. Apart from that Changes in Expectations and Speculative Bandwagons also create volatility in the market. Reasons for Central Banks Interventions on Foreign Exchange Markets For Minimization of the Overshooting Effect The policy makers are on the opinion that central bank intervention is of utmost important for the purpose of stabilization of the economy, the exchange rate, for providing liquidity in the market and to be more specific, to prevent the overshooting effect, in either direction. This is the short term tool used by most of the central banks for smoothening the exchange rate transition by nullifying the overshooting effect when the policy makers assume a changing economic signal (Dominguez, 2004). For Controlling the Exchange Rate Volatility As an increased level of volatility adversely affects the sentiment of financial market and the market economy, central banks strive to reduce the incidence and extent of exchange rate volatility. Central bank tends to reduce volatility because such factors hinder international investment flows. As volatility is associated to business risk, the institutional investors presume the risk correlated with the return on foreign investment; hence exchange rate volatility tends to reduce investments in foreign financial asset. Uncertainty in profit motive restricts the incentive of global companies to expand, decreases domestic investment which in turn leads to inefficient allocation of existing resources of world economy (Clark and Ghosh, 2004). All these factors arising out of volatility in exchange rate minimize the scope for international trade. For the existing international trade, exchange rate volatility reduces business profit and as the risk factor increases, the companies tend to append a risk premium for safeguarding the profitability. Therefore, the additional cost is extracted from the consumers themselves in the form of higher prices in order to keep their profitability unchanged. In summation, exchange rate volatility may result in hindering the international trade as a whole and will lead to hamper the entire financial system in the world economy. Hence, central bank intervention is required (Malloy, 2013). Leaning Against the Wind Central bank intervention is required to resist the short term movements in exchange rate which is more prominent in countries with floating exchange rates. The “Leaning-against-the-wind” strategy or central bank’s effort to intervene disorderly markets by providing support to either of the domestic and foreign currencies helps the economy to keep a check on such short run fluctuations. Medium range misalignments related to exchange rates are also stabilized by central bank intervention and exchange rate market is brought back to its initial equilibrium position (Mandeng, 2003). Profitability Intervention Empirical studies have proved that profitability intervention is required mainly in major industrial countries with floating exchange rate system for controlling the substantial loss due to the frequent interest rate differential between investments in foreign country and home currency and for helping the countries to achieve their macroeconomic goals such as employment and price stability (Corporation Essvale Corporation Limited, 2008). Effectiveness of Central Bank interventions Though the significance of central bank intervention has already been ascertained, effectiveness of such intervention is yet to establish. It is also manifested that the central bank intervention may increase or decrease the degree of volatility, depending on the economic and financial circumstances prevailing in the economy (Hesse and Frank, 2009). Decreasing Volatility as a result of Intervention In situations, when exchange rate volatility arises out of introduction of a new policy regulation or initiation of policy changes in the monetary framework of a country, central bank intervention leads to reduce volatility in exchange rate market. This is achieved through central bank’s effort to minimize uncertainties in market regarding the monetary policy. For instance, if there is bewilderment in the economy regarding the state of monetary policy, an initiative of central bank to halt a drop in dollar will signal the investors and traders that the Federal Reserve is aiming at tightening the monetary policy. Such initiative will eliminate investors’ confusing and enable them to take a firm decision which will lead to reduce the extent of volatility in exchange rate system (Federal Reserve Bank of Cleveland, 2014). Increasing Volatility as a result of Intervention When the uncertainty in the market place originates from private sector uncertainty, the central bank’s initiative to intervene may actually result in increase in the volatility in exchange rate market. For example, central bank may plan to surprise traders to increase the value of dollar through intervention operations. Though there is no other motivation of central bank to influence investment magnitude, it is up to the investors that how they will interpret this attempt of central bank. Hence, as a result of having incomplete information, such action taken by central bank creates considerable amount of confusion among the investors and the traders tend to revise their current holding position according to their own assumptions that varies across the group of traders. Naturally, such action initiates exchange rate volatility to a great extent. Therefore, stimulating from intervention activities, future intervention plans of central bank creates further uncertainty among investors which may contribute towards larger exchange rate volatility (Kamil, 2008). The Hedging Decision of Beazley Development Plc Beazley Development Plc is a medium sized manufacturing company with business operations in USA and Europe. The treasury department of the company is expected to receive $10,000,000 through selling of one of its subsidiaries in USA. On 1st of February, 2015 the spot rates available to the treasury are: $/£ Spot Exchange rate: $1.6462- 1.6474 For simplification of calculations, converting $10,000,000 into pound sterling = £ (10,000,000/1.6462) = £ 6074596. At the end of August, 2015 the spot exchange rates available to the company are $/£ Spot Exchange rate: $1.48 – $1.50. As the future spot exchange rate is below than that of the present rate, the company should take short position i.e. Beazley Development Plc should sell the contract at a high spot rate available at $1.6462 and gain from taking a long position in future by buying the contract at the future spot rate of $1.48. The net gain of the company from adopting this hedging strategy can be attributed as = £ [6074596 x (1.6462- 1.48)] = £ 1009597.8552. Considering the Future Contracts, as some of the treasury department is anticipating that dollar will weaken against pound. Hence, the department is aiming at hedging the currency risk. Given the March, June and September contract as $1.6551, 1.6565 and 1.6600 respectively whereas the Future Price is appreciating at $1.50 which means the dollar is becoming stronger rather than weaker. Hence, the company will incur a loss if they are planning for a hedging with a wrong assumption. Conclusion Form the above discussion it is prominent that monetary policy changes and central bank intervention operations often influence volatility in exchange rate market. It is also evident that the effect of central bank intervention is situation specific. For instance, secret interventions tend to create more ambiguity in market which leads to increase the degree of volatility in the system (Rheinlander and Sexton, 2011). Therefore, if the central banks run the intervention operations in a large and coordinated manner and more specifically, they publicize the intervention much before the process is supposed to take place, the investors and traders will be able to have a complete information based on which they will be able to take inform decision. If the central banks run the intervention in a more careful manner, the world will experience the effectiveness of the intervention process. Reference List Beine, M., Laurent, S. and Lecourt, C., 2001. Official Central Bank Interventions and Exchange Rate Volatility: Evidence from a Regime Switching Analysis. [PDf] Retrieved from: < http://www.timberlake.co.uk/slaurent/pdf/Markov.pdf> [Accessed 3 February 2015]. Beinea, M., Quéré, A. B., Dauchyc, E. and MacDonald, R., 2003. The Impact of Central Bank Intervention on Exchange Rate Forecast Heterogeneity. [PDf] Retrieved from: < http://www.cepii.fr/PDF_PUB/wp/2002/wp2002-04.pdf > [Accessed 2 February 2015]. 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