Government Influence on Exchange Rates

1
Government Influence on Exchange Rates

• Understanding the role that governments play in
  influencing exchange rates

2
Government Activities that Influence Spot
Exchange Rates

• The foreign exchange regime that the government
  adopts.
• Independent float, managed float and pegs.
• Recall that market forces can result in forced
  changes in foreign exchange regimes.
• UK in 1992 Asian economies during the Asian
  currency crisis of 1997, etc.
• Direct and indirect government intervention in
  foreign exchange markets.

3
Why do Governments Attempt to Influence Exchange
Rates?

• To react to what the government feels is an
  unwarranted level of the spot rate.
• Generally done when the exchange rate threatens
  domestic economic activity.
• Japans intervention on September 15, 2010
• To respond to temporary disturbances.
• Generally done when sudden and unanticipated
  events produce extreme moves in exchange rates.
• Offsetting safe haven effects.
• To establish and maintain implicit and explicit
  exchange rate boundaries.
• Done within the context of a pegged or managed
  exchange rate regime.

4
Direct and Indirect Intervention

• Direct Intervention
• Buying and selling currencies in foreign exchange
  markets.
• Buying weak (depreciating) currencies and selling
  strong (appreciating) currencies.
• Indirect Intervention
• Government adjusting domestic interest rate.
• Raising interest rates to support weak
  (depreciating) currencies and lowering interest
  rates to offset strong (appreciating) currencies.
• Foreign exchange controls.
• Restrictions on the exchange of currency (i.e.,
  the type and amount of transactions).

5
Direct Intervention

• Through direct intervention in foreign exchange
  markets, governments are attempting to offset
  market forces on spot exchange rates.
• If market forces strengthen a currency, a
  government (central bank) could respond by
  selling the strong currency (and buying the weak
  currency) into the foreign exchange market (thus
  meeting market demand for the strong currency).
• When the government does so, it accumulates
  international reserves (i.e., the weak currency
  it is buying).
• If market forces weaken a currency, a government
  (central bank) could respond by buying the weak
  currency (and selling the strong currency) on the
  foreign exchange market (thus reducing the supply
  of the weak currency).
• When the government does so, it uses its
  international reserves (i.e., the strong
  currency it is selling).

6
Direct Intervention to Support a Weak Currency

• Why is the Currency Weakening?

• Impact of Intervention

• Markets moving out of that currency into another
  currency (i.e., into the preferred currency).
• Interest rate differentials, safe haven effects,
  trade flows, political and economic risk, asset
  bubbles, expectations of changes in peg, etc.
• Government needs to buy its currency to offset
  market selling.
• Either unilaterally or through cooperative
  intervention.

• As the government is buying its weak currency, it
  is also supplying the currency that the markets
  are moving into (i.e., the preferred currency).
• In doing so, the government is reducing its
  international reserves (i.e., the key currency
  the market is preferring).
• Success of this direct intervention depends on
  governments supply of international reserves and
  extent of international cooperation.

7
Direct Intervention to Offset a Strong Currency

• Why is the Currency Strengthening?

• Impact of Intervention

• Markets moving into that currency (i.e., the
  preferred currency) and away from other
  currencies.
• Interest rate differentials, safe haven effects,
  trade flows, political and economic risk,
  expectations of changes in peg, etc.
• Government needs to sell its currency to offset
  market demand.
• Either unilaterally or through cooperative
  intervention.

• As the government is selling its strong currency,
  it is essentially supplying the currency that the
  markets are moving into (i.e., the preferred
  currency).
• In doing so, the government is increasing the
  supply of its currency in foreign exchange
  markets and also potentially in its own domestic
  market.
• The potential impact of increasing the countrys
  domestic money supply is to accelerate
  inflationary pressures and inflationary
  expectations for that economy.
• Success of this direct intervention depends on
  the extent of international cooperation.

8
Non-sterilized Versus Sterilized Direct
Intervention

• Non-sterilized Intervention

• Sterilized Intervention

• Defined as a central bank not taking any action
  to offset the increase (or decrease) in the
  countrys domestic supply resulting from direct
  intervention to offset a strong (weak) currency.
• Likely to be followed if the central bank is not
  concerned about inflationary impacts or impacts
  on economic activity.
• For example, Japan today.

• Defined as a central bank using monetary policy
  actions to offset the increase (decrease) in the
  country domestic money supply resulting from
  direct intervention to offset a strong (weak)
  currency.
• Usually done through central bank open market
  operations, specifically selling or buying
  government securities through domestic financial
  institutions.
• Sales of government securities will reduce bank
  reserves and purchases of government securities
  will increase bank reserves (see slides which
  follow).

9
Text Book Exhibit of Non-sterilized Versus
Sterilized Intervention

• The illustration below shows an example of the
  U.S. Central Bank (i.e., the Federal
  Reserve)intervening to offset a strong US dollar
  against the Canadian dollar.
• The Fed wants to weaken the U.S. dollar and
  strengthen the Canadian dollar.

10
Text Book Exhibit of Non-sterilized Versus
Sterilized Intervention

• Intervention can also produce reductions in a
  countrys domestic money supply (i.e., if the
  government is buying its currency and selling the
  preferred currency).
• In the illustration below, the Fed has used
  direct intervention to strengthen the U.S. dollar
  and weaken the Canadian dollar (i.e., offset USD
  selling on FX markets)

11
Indirect Intervention

• Indirect intervention generally involves two
  possible actions
• Adjusting domestic interest rates.
• Raising interest rates to support a weak currency
  i.e., increasing the interest rate differential
  in favor of the weak currency country.
• September 18, 1992, the Swedish Central Bank
  raised its marginal lending rate to 500 to
  temporarily stem speculative pressures against
  the krona (SEK). At the time the krona was pegged
  to a trade-weighted basket of 15 foreign
  currencies (peg was dropped in December of 1992
  and an independent float was adopted).
• Lowering interest rates to offset a strong
  currency i.e., decreasing the interest rate
  differential in favor of the strong currency
  country.
• Assumption is that by adjusting the interest rate
  differential, the demand for the currency is
  affected.
• Problem with interest rate adjustments
• This policy may be inconsistent with domestic
  economy conditions and required monetary policy
  stance for those conditions.
• For example, the U.K. in 1992 when part of the
  Exchange Rate Mechanism (ERM) UK needed lower
  interest rates to stimulate domestic demand, but
  higher interest rates to maintain exchange rate
  in ERM.

12
Raising Interest Rates to Defend a Currency

• Interest Rates During the Asian Currency Crisis

• Interest Rates in Argentina, 2002 _at_ 125 in August

13
Indirect Intervention

• A second type of indirect intervention involves
  the use of foreign exchange controls.
• Defined Government restrictions on transactions
  in the foreign exchange market.
• Regulations on convertibility
• Setting the amount of foreign exchange a resident
  can purchase and/or setting limits on the amount
  of foreign exchange a domestic company can hold
  (from foreign sales) and thus must sell excess
  back to government.
• Viet Nam Ordinance On Foreign Exchange Controls
  (Jan 31, 2010) Residents must remit all foreign
  currency amounts derived from export of goods and
  services into a foreign currency account opened
  at an authorized credit institution in Vietnam.
  If residents wish to retain foreign currency
  overseas, they must obtain approval from the
  State Bank of Vietnam.
• Regulations on market makers
• Central bank (or government agency) is the only
  bank authorized to conduct foreign exchange
  transactions.
• Regulation on types of transactions (i.e.,
  capital controls)
• Permitting foreign exchange transactions
  resulting from commercial transactions, but not
  from speculative transactions (e.g., closing
  the markets for short term capital flows).
• In 1997 (Sep 1), Malaysia, in response to the
  ringgit currency attack, imposed capital
  controls which essentially closed down
  transactions in short term capital movements out
  of the ringgit by requiring that any investment
  transactions involving ringgits had to be held
  for 12 months in approved banks. Restriction was
  lifted in December 2000.

14
Case Study of Malaysias Response to the 1997
Currency Crisis

• Sequence of Events

• Exchange Rate USD/MYR

• During the mid 1990s, Malaysia attracts a
  substantial volume of volatile capital (short
  term and portfolio i.e., mobile capital) which
  were driven by the boom in the equity market (an
  equity bubble occurs).
• FDI investment peaks in 1996 but volatile
  capital inflows continue to rise.
• May 14-15, 1997 Malaysia ringgit comes under
  attack. At the time the ringgit is highly
  managed to the USD (_at_a rate of 2.5).
• Part of a contagion effect in Asia (started in
  Thailand)
• Market concerns about weak corporate governance
  and weakness in the financial sector in Malaysia
  results in outflows of volatile capital.
• July 2, 1997, Malaysia drops its managed float,
  and the ringgit falls 18, but the government
  continues to use direct intervention to support
  the currency. Malaysia continues to raise
  interest rates during the crisis.
• September 1, 1997, Malaysia imposes a set of
  capital controls which shut down the offshore
  market in ringgit and stop speculative trading.
• September 2, 1998, Malaysia introduces a peg
  regime (_at_3.8).
• Capital controls are lifted from Feb 1999 through
  Jan 2003.
• July 21, 2005, Malaysia announces abolition of
  the ringgit peg in favor of a managed float.

15
Case Study of U.K. Currency Crisis of 1992

• Background

• Germanys Role in the ERM

• Britain joined the European Exchange Rate
  Mechanism (ERM) in October 1990.
• ERM was designed to promote exchange rate
  stability within Europe.
• Under the ERM, European currencies were pegged
  to one another at agreed upon rates.
• In October 1990, the British pound was locked
  into the German Mark at a central rate of about
  DM2.9/
• General feeling at the time was that this rate
  overvalued the pound against the mark.

• While the ERM included many European countries,
  Germany was the leading player because of its
  economic dominance.
• Thus, the German mark was also the dominant
  currency in this arrangement and German monetary
  policy set the tone for the rest of the ERM
  members.
• Thus, German monetary policy had to be followed
  by the other members in order for the other
  member states to keep their currencies aligned
  with the German mark.
• This was especially true with regard to Germanys
  interest rate.

16
Case Study of U.K. Currency Crisis of 1992

• Events Leading up to the Speculative Attack

• The Attack and Response

• Pound currency attack begin in September 1992
• Short selling of the pound was led by hedge
  funds particularly George Soros.
• The British Governments initial response to the
  attack occurred on Wednesday, September 16
• Government raised interest rates twice from 10
  to 12 and then to 15
• Attempt to make U.K. investments more attractive.
• During the attack the Bank of England used 4
  billion in hard currency in defense of the pound.
  Bank of England bought 4 billion worth of pounds
  which were being sold short (it did this by
  selling U.S. dollars and German marks to
  speculators).
• Estimates 1/3 of its hard currency was spent.
• On Wednesday at 7pm (UK time), the U.K.
  government announced they would be leaving the
  ERM the next day and that interest rates would go
  back to 10. (referred to as Black Wednesday).
• Thursday, September 17, the pound returned to an
  independent float.
• By late October, the pound had fallen about 13
  against the mark and 25 against the U.S.

• While the markets felt the pound was overvalued
  when it joined the ERM, a combination of two
  critical events, one just before and a second
  just after Britain joined the ERM convinced some
  in the market that the pound was now ready for
  speculation.
• These events were
• The fall of the Berlin Wall in Nov 1989
• The economic recession in the U.K. in 1991-92.
• Fall of the Berlin Wall As a result, German
  decided to raise interest rates in order to
  attract needed capital for the reunification of
  East and West Germany.
• Other ERM countries need to follow with higher
  interest rates.
• UK Recession However, the issue for the U.K. was
  having to raise interest rates during their
  recession.
• A recession would be properly addressed by lower
  interest rates.
• Thus there was both a political and economic
  component to the potential decision to raise
  rates.
• Markets thought the UK would not be willing to
  raise rates to defend the pound.

17
Sterling Exchange Rate Around the Time of the
1992 Crisis

• GBP/DEM

• GBP/USD