Impact of Central Bank Interventions on the Foreign Exchange Markets - Literature review Example

Impact of central bank interventions on the foreign exchange markets Table of Contents 0 Introduction and intended outcomes 2 2.0 Literature Review- Research Specific  2 2.1 Characteristic the different exchange rate systems prevailing around the world 3 2.1.1 The implications of each exchange rate regime on exchange rate volatility 4 2.2 The reasons for Central Banks interventions on foreign exchange markets 4 2.3 The effectiveness of Central Bank interventions 5 2.4 An overview of some of the critical researches on the impact of intervention policies 5 2.4.1 Significance of policies impact 6 2.4.2 Intended versus unwanted effects 6 2.4.3 Potential waste of resources 6 3.0 Conclusion 7 1.0 Introduction and intended outcomes Intervention of central bank in foreign currency and its impact on volatility of foreign exchange rate is widely targeted by economists, concerned institutions, and academic researchers during recent fast-paced era of economic and international trade pattern changes. The issue seems critical to be validated in one favorable or unfavorable direction via empirical implications, due to which there is no agreement seen in views of critics (Dominguez, 1998). The contrasting views leave a wide area of discussion about the issue. Assessment of interventions and its outcomes is necessary in accordance with central bank’s intentions of achieving particular goals via intervening in foreign currency market. Further it is important to assess the impacts of various components that are interrelated in the regard. Those components include exchange rate regime selection, impact of interventions on volatility of foreign market and on overall economic system. The paper presented is an effort to evaluate underlying issue critically by understanding and reviewing previous empirical evidence based studies about the matter. For the purpose, paper develops a literary review via exploring the implications, significance and probaility of adverse results in terms of inteneded and unplanned outcomes of central bank interventions policies. 2.0 Literature Review- Research Specific  Exchange rate volatility is considered as a driver for financial market condition and central bank intervene in the system by utilizing monetary policy to maintain the balance in between stability and volatility of the exchange rate (Karacadag, Pereira, & Ishii, 2006). The statement suggests viability of impact of the intervention on the trends of exchange rate. The efficacy of the impact of the intervention is highly questioned by researchers and market analysts in terms of favorable, unfavorable or irrelevant. There is one lot who thinks that intervention of central bank negatively impact on the foreign currency exchange rate and increase its volitility (Bènassy-Quéré, & MacDonald, 2007). While, another group suggests that it stabilizes the phenomenon and decreases its volatility (Dominguez and Frankel, 1994). Finally, one school of thought suggests that central banks intervention does not affect foreign exchange rate and emerges losses of resources due to higher depreciation rates (Mbarek, Rachdi and Mensi, 2011) including tax payer’s money. Moreover, Need and level of intervention is highly dictated by the adopted exchange rate regime by the country for controlling and driving economic indicators. Reviewing and considering the implications of contrasting views and need of interventions, following sections are crafted to examine the components and impacts of those components that actively accounted for effectiveness of central bank’s intervention in the foreign exchange market. 2.1 Characteristic the different exchange rate systems prevailing around the world Mainly IMF categorizes exchange rate regimes into two types namely fixed and floating. Both the systems hold different characteristics and a set of pros and cons for economies. A Fixed exchange rate is set by central bank of any economy and considered as official exchange rate. In this system, the worth of the currency is fixed or pegged to any major currency of the world (Kamil, 2008). In this scenario, the central bank is obligated to keep high foreign reserves in order to drive local economic situation where control of economic indicators including currency, inflation or deflation is required. On the other hand, floating regimes is derived by local market trends. Actual market supply and demand determines the exchange rate in floating system and thus allows the elimination of overvalued implications of the fixed currency rate. The economic system of supply and demand controls many of the indicators itself due to driving a factor of demand in the economy. So, the system is accredited for less obligation imposition on central bank for maintaining foreign reserves and thus built a more flexible economic system while central bank in floating system intervenes where stability or control of drivers required. Both the systems separately or with a viable mix are practiced today by different countries. The choice of the practiced regime depends on the need of a particular country, as IMF explains the choice of exchange rate regime of the countries in current integrated world’s economic scenario (IMF, 2000). IMF document suggests that developing and emerging economies should adopt floating regime in order to prevent economies from monetary crisis. The grounds for the suggestion are considered the crisis periods of Mexico and Brazil, Russia and Asia in 1997-1999 (IMF, 2000). The inclination of suggestion is aligned with the theory of (Dominguez, 1986) who indicated flexible exchange rate era. To convert the regime into floating one and maintain the volatility, emerging markets intervene on the basis of defined rules that lower volatility of exchange rate in country’s market (Basu, & Varoudakis, 2013). IMF research provides evidence that emerging economies’ central banks intervene in order to maintain reserve balance via buying and selling to respond to the pressures of appreciation and depreciation in short and medium run (IMF, 2000). 2.1.1 The implications of each exchange rate regime on exchange rate volatility Fixed allows pegging of the currency, which holds worth of currency and make it stable. While, floating system drives the economic system efficiently by driving the economic indicators via selfderive of demand thus increase the volitility of the exchange rate, so the use of both techniques allow economies to survive well in emerging integrated world’s economy. However, fixed regimes requires higher foreign currency reserves that at times over valuate the currency of the country. On the other hand, it is evident that floating system at times leads the exchange rate towards critical level of volatility which creates the need of intervention to control the market and prevent from economic shocks. Usually, economies play with a mixed set of regimes in the international market regarding currency exchange rate to gain the advantages and eliminate adversities associated with both regims. Williamson, (2000) adds the novel concept of capital mobility and suggests that now the regimes era is ruling out due to capital mobility in between economies. 2.2 The reasons for Central Banks interventions on foreign exchange markets Normally, the central bank intervenes in the floating markets to counter the economy from short-term disruptive trends of the international exchange markets. Defining as sales or purchase of foreign currency reserves central banks of most of the countries intervene (Dominguez, 1998) in the foreign exchange systems for any specific reasons or in accordance with the country’s rules to keep the economy stabilized. The effectiveness of the intervention is judged by how well bank sterilized the impact of the intervention in the economy to prevent the liquidity (Inoue, 2012). There are specific goals, which an economic institution of any economy holds when intervene in foreign exchange system. Generally, it is said that the central bank intervene in the foreign exchange system for correcting exchange rate misalignments, volatility of the local economy or to control economic indicators (Moura, Pereira, & Attuy, 2013). Basu and Varoudakis, (2013) however suggested specific main reasons or implications due to which central bank of an economy decides to intervene in the monetary system. According to the study presented by Basu and Varoudakis (2013), the central bank intervenes to maintain a particular level of exchange rate through crawling or pegging against currency baskets or other currencies. Secondly, it may be to control volatility level of exchange rate in the market, to manage reserve levels of the country and/or valuation of currency. They further stated that the justification for intervention is that exchange rates can not only absorb, but also create economic shocks and interventions aid in managing those phenomena (Basu and Varoudakis, 2013). 2.3 The effectiveness of Central Bank interventions It is widely accepted that it is the way of sterilization of intervention that affect or not the monetary levels of a country. Timely decision of intervention found important in this aspect. Intervention of a country influences volatility to be increased if accompanied by other countries’ policies and are dependent on the market conditions of exchange rate volatility. Interventions if targeted on a specific benefit for the economy in a timely manner can be effective for short-run and aid the central bank in correcting the located measure. Moreover, for emerging economies, exchange rate volatility becomes higher due to spending behavior and temporary policy making. Thus, crisis risk for emerging countries is higher. Intervention of central bank found effective where control of volatility for the sake of preventing from economic shock is utilized. 2.4 An overview of some of the critical researches on the impact of intervention policies The central banks of economies with floating exchange rate usually intervene in the system for the purpose of controlling economic indicators or maintaining balance of reserves level. For instance, Brazilian government always intervenes in country’s foreign exchange market after adopting floating system after economic crash due to dependency on pegging system since 1999. The major reason for intervening of Brazil central bank is to restore its reserves level back and decrease the dependency on volatility of US dollar (Basu, & Varoudakis, 2013). The purpose of the intervention sound effective if applied and executed cautiously. Considering the phenomena, below is discussed the favorable and adverse impacts of interventions via reviewing country cases researched by authors of the field. 2.4.1 Significance of policies impact The significance of the intervention is measured by many of the researchers by considering inventing governments as sample. For instance, (Domac and Mendoza,) studied the intervention outcomes considering Turkey and Mexico as sample nations. The timely frequent interventions made by these countries under inflation pressure had drecreased the volatility of exchange rate. This, in turn, strengthen the hypothesis that if intervention is well-planned and executed correct aid in controlling volatility of exchange market. Another empirical study conducted by (Kurihara) for Japanese intervention proved to be effective in influencing exchange levels and appreciation/depreciation of Japanese currency against US dollar. Although empirical evidence for the phenomena is found mixed, but the overall impact is present (Kurihara, 2011). 2.4.2 Intended versus unwanted effects It is not always evident that volatility of the market can be influenced by intervention; there are inherited risks of unwanted outcomes. Considering the case analysis of India, (Inoue, 2012) empirically evaluated the intervention of Indian central bank in terms of net purchases of foreign currency and found not to influence the volatility of the exchange market (Inoue, 2012). One other major benefit that is pursued by governments is to provide liquidity to the financial markets in order control bubbling chaos of financial markets that is created due floating operations in personal interest (Engert, Selody, & Wilkins, 2008). 2.4.3 Potential waste of resources Devaluation in currency of the country is potential resource wastage of the country due to unnecessary or poorly executed intervention. For instance, as evident in the case of India, purchases of foreign reserves were continuously made but did not have any effect on volatility of the market. The counter effects Indonesia and India faced are the depreciation of their currencies and lowered currency value in world’s commodity market due to the intervention in the exchange market intended to control volatility of the market. Further, Intervention in volatile markets and emerging economies are found effective at some point in time but if it is practiced in a stable regime of exchange rate result in waste of resources (Hisali, 2012). 3.0 Conclusion Summing up the empirical literary review it can be concluded that the interventions of central banks become necessary at some point in time with a specific rationale. Chosen regime is one of the important aspects of the phenomenon of intervention. It is suggested that market pressures in accordance with chosen exchange rate regime is also driving the force for the central bank to intervene in the market. Central banks’ interventions if synchronized and sterilized correctly, aids economies in balancing the market and economic indicators. This in turn aid in maintaining economic condition of the currency of a particular country against pegging currencies or basket of currency. On the other hand, mishandling of the matter or following specific hardcore rules of intervention instead of understanding market requirement can lead to disasters. Emerging economies utilizes intervention more often to maintain volatility of emerging financial markets which is a need in many scenarios. However, the intervention in floating market is considered to be effective but the same for a stable market can be turned into a disaster for the economy. Further, if the invention is not well-planned and, outcomes are not cautiously forecasted lead country towards wastage of the precious resource that is the currency. References Basu, K., & Varoudakis, A. (2013). How to move the exchange rate if you must: the diverse practice of foreign exchange intervention by central banks and a proposal for doing it better. Beine, M., Bènassy-Quéré, A., & MacDonald, R. (2007). The impact of central bank intervention on exchange-rate forecast heterogeneity. Journal of the Japanese and International Economies, vol. 21, no. 1, pp. 38-63. Cooper, R. N. (1999). Exchange rate choices. Harvard Institute of Economic Research, Harvard University. Dominguez, K. M. (1998). Central bank intervention and exchange rate volatility. Journal of International Money and Finance, vol. 17, no. 1, pp. 161-190. Dominguez, K. M., & Frankel, J. (1994). Does foreign exchange intervention matter? Disentangling the portfolio and expectations effects for the mark (No. w3299). National Bureau of Economic Research. Edwards, S., Cavallo, D. F., Fraga, A., & Frenkel, J. (2003). Exchange rate regimes. In Economic and financial crises in emerging market economies. University of Chicago Press. Engert, W., Selody, J., & Wilkins, C. (2008). Financial Market Turmoil and Central Bank Intervention. Available from http://www.bankofcanada.ca/wp-content/uploads/2012/01/fsr-0608-engert.pdf [Accessed 15th January, 2015] Gilpin, R. (2011). Global political economy: Understanding the international economic order. Princeton University Press. Hisali, E. (2012). The efficacy of central bank intervention on the foreign exchange market: Ugandas experience. Journal of International Development, vol. 24, no. 2, pp. 185-207. IMF. (2000). Exchange Rate Regimes in an Increasingly Integrated World Economy. Available from https://www.imf.org/external/np/exr/ib/2000/062600.htm [Accessed 15th January, 2015] Inoue, T. (2012). Central bank Intervention and Exchange Rate Behaviour. IDE Discussion Paper, Available from http://www.ide.go.jp/English/Publish/Download/Dp/pdf/353.pdf [Accessed 15th January, 2015] Kamil, H. (2008). Is central bank intervention effective under inflation targeting regimes? The case of Colombia. International Monetary Fund. Karacadag, C., Pereira, G., & Ishii, S. (2006). Official Foreign Exchange Intervention (No. 249). International Monetary Fund. Kurihara, Y. (2011). Intervention in the Foreign Exchange Market and Exchange Rates in Japan. 経営総合科学, (96), 85-91. Mbarek, H. B., Rachdi, H., & Mensi, S. (2011). The Effect of Central Bank Intervention on the Exchange Rate of the Tunisian Dinar in Relation to the European Currency. Journal of Business Studies Quarterly, vol. 2, no. 3. Moura, M. L., Pereira, F. R., & Attuy, G. D. M. (2013). Currency wars in action: How foreign exchange interventions work in an emerging economy. Insper Working Paper, Insper Instituto de Ensino e Pesquisa. Williamson, J. (2000). Exchange rate regimes for emerging markets: reviving the intermediate option. Peterson Institute. Read More